Tax Doctor: whether to take a lump sum or income on death

The case

Casper is aged 74 and has an uncrystallised pension pot worth £1,373,100. He is a widower and has a grown-up son and daughter.

He tells his adviser that he understands the lifetime allowance has now been abolished. He wants to check how his son and daughter can use any pension pot remaining on his death. Casper tells his adviser his son wants an income, and his daughter would like a lump sum.

The diagnosis

Casper’s financial adviser starts by telling him that the lifetime allowance has not yet been abolished. Instead, the new rules for this tax year state that no lifetime allowance charges will arise.

There were two different rates of lifetime allowance charge: 25% if the excess was paid as income, and 55% if the excess was paid as a lump sum. This latter figure was based on a combination of a 25% charge plus income tax, assuming that the recipient was a higher-rate taxpayer. The new rules for 2023/24 get rid of only the 25% charge.

This means that on a benefit crystallisation event if the excess is paid out as income there is no charge. But if it is paid out as a lump sum then although the 25% lifetime allowance charge disappears, the charge to income tax still applies (based on the recipient’s tax rate).

The adviser explains the rules, assuming that there would be no growth on Casper’s pension fund, and that there would be an excess of £300,000. They also assume (for illustration purposes) that the benefits would be split equally between the children with each one receiving 50% of £1,073,100 and 50% of the £300,000 excess.

What tax charges apply depends on whether Casper dies before his 75th birthday or not.

Dies after 75

All the lifetime allowance checks will have been done when Casper reached age 75. Casper’s son wants to receive an income so his share of £686,550 is paid into a beneficiary’s drawdown arrangement. Any withdrawal will then be subject to income tax.

Casper’s daughter would like to receive a lump sum. Again, the total amount will be subject to income tax. However, because she is taking a lump sum rather than a series of payments, she is likely to pay more tax than her brother.

Dies before 75

If Casper dies before age 75, then there is a benefit crystallisation event on the uncrystallised funds. As Casper’s son wants to take his share of the excess as income, there is no lifetime allowance charge. Instead, the full amount is paid into the beneficiary’s drawdown arrangement. However, as Casper died before age 75, whatever income his son withdraws will not be subject to income tax.

However, Casper’s daughter will face a tax charge. Although she can take her share of the benefits up to the lifetime allowance as a lump sum without paying income tax, she will have to pay income tax on the part deriving from the excess.

This puts her in a worse financial position than her brother.

If she really wants a lump sum, the easier option is to choose to take the whole amount as income, place it in a beneficiary’s drawdown arrangement, and then withdraw it as a lump sum. That way she escapes an income tax charge.

Who calculates and pays the income tax on the excess?

The legal personal representatives (LPRs) are responsible for calculating whether there is a lifetime allowance excess on death where any uncrystallised pension is paid out as a lump sum. HM Revenue & Customs will work with the LPRs to establish if there is a tax charge and how it is payable.