Tax Doctor: How pension benefits are taxed after death

The case

Helen is 72 years old and, unfortunately, has just received a terminal cancer diagnosis. She wants to sort out her finances in the next few months, including her pension.

Helen took partial benefits from her SIPP five years ago, using all of her £1 million lifetime allowance, but leaving some funds uncrystallised. Her pension now has drawdown worth £1,100,000 and uncrystallised pension worth £150,000

She would like her grown-up daughter Alice to receive her pension funds when she dies. Alice is a higher rate taxpayer.

Helen would like to understand how her pension benefits will be taxed when she dies and what the implications are for Alice.

The prescription

Helen should first complete an expression of wishes form nominating Alice to receive her pension on death. Alice is not a dependant, but as a close relative, and beneficiary of Helen’s will, it’s likely the pension trustees will decide to pass her the pension fund. If she is not a nominee, she may not have the option of taking the pension as income and may be forced to take it as a lump sum.

First let’s look at Income Tax. As Helen is under 75 when she dies, as long as the funds are designated within two years, Alice will not pay any Income Tax on the money when she withdraws it, regardless of whether she takes a lump sum or drawdown income.

Now, let’s look at lifetime allowance charges. There are three different benefit crystallisation events (BCEs) that apply on death before age 75 – when uncrystallised funds are designated to drawdown, are used to provide an annuity, or a ‘relevant’ lump sum is paid.

For crystallised funds, as there has already been a BCE, there is no further test against the lifetime allowance. This is despite Helen’s drawdown fund increasing since she originally designated it.

However, there will be a BCE against the uncrystallised fund if it is designated within two years. As Helen has used up her whole lifetime allowance, the whole of the uncrystallised fund will be treated as excess and subject to a lifetime allowance charge. If Alice takes the fund as a lump sum, then a 55% tax charge applies. If she takes it as drawdown, then the tax charge is reduced to 25%.

It’s worth recapping that the government envisaged, for lifetime benefits, that the lifetime allowance charge payer would be a higher rate taxpayer after retirement. An initial 25% charge followed by a 40% Income Tax deduction equates to a 55% charge overall.

For a death benefit case like this, as no Income Tax will be applied, the charge will only be 25%. It will be more tax-efficient for Alice to take drawdown rather than a lump sum, and that is why it’s so important Helen nominates her. If Alice just wants a lump sum and not a steady income, she can always designate to drawdown first, take the 25% charge hit, and then remove all the remaining £112,500 from the drawdown fund with no further charge or tax.

In life, the member and the scheme administrator are jointly responsible for paying any lifetime allowance charge. On death, the beneficiary is solely responsible for paying the charge. Helen’s personal representatives will assess whether the lifetime allowance has been exceeded. They should confirm details of all pension schemes and the chargeable amount to HMRC, who will then write to Alice to request the tax charge of £37,500 (25% of £150,000). She will have 30 days to pay the charge.

One final point. If funds are designated within two years, Alice won’t have to pay Income Tax but will have to pay a lifetime allowance charge. However, if funds are not designated within this period, then the opposite applies. Alice will have to pay Income Tax but not a lifetime allowance charge. For Alice this will be a higher amount, so it’s important to meet the two-year deadline.