Lump sum death benefits, explained

When a pension scheme member dies, their pension can be paid out as a lump sum to individual beneficiaries, to trusts and / or to charities.

As part of our Bitesize Technical series, Senior Technical Consultant Lisa Webster looks at the rules around lump sum death benefit payments from defined contribution pensions, and how they are treated for tax.

Please note: These are the current rules for pension death benefits. Changes to the tax treatment are due to come into force from 6 April 2027.

Key insights on lump sum death benefits

Member dies before 75th birthday and lump sum paid to an individual

The lump sum can usually be paid tax free, but there are a couple of scenarios where tax will apply:

1. Lump sum and death benefit allowance (LSDBA) test

   On death under age 75, the maximum lump sum that can be paid tax free is limited by the available LSDBA. The standard LSDBA is £1,073,100, however, if the member took tax-free lump sums in their lifetime, they may have used up some of this allowance.

   If the death benefits are paid from funds that were put into drawdown prior to 6 April 2024, then these shouldn’t be tested against the LSDBA, but any other funds will be.

   Any lump sum death benefits paid out above the available LSDBA will be subject to income tax for the beneficiary receiving the payment.

   This may not be a priority for the new government, but it is welcome, nevertheless. There are six different types of ISA – with the last government threatening to introduce a seventh in the form of a UK ISA. We need to cut the confusion people face and give them confidence to make that jump to become a saver or investor.  
    
2. Two-year rule

   To remain tax free, the death benefit lump sum must be paid out to the beneficiary within two years of the date the scheme administrator knew, or should reasonably have known, of the member’s death. If the payment is made after this two-year window, then there is no test against the LSDBA, but the entire lump sum will be subject to income tax.

Member dies on or after 75th birthday and lump sum paid to an individual

On death at age 75 or above, there is no test against the LSDBA, but the whole lump sum payment will be subject to income tax for the recipient.

Lump sums paid to a trust

If the lump sum payment is made to a trust, the rules are broadly the same as for payments to individuals. However, where income tax would apply to an individual, the ‘special lump sum death benefits charge’ applies instead. The rate of this charge is 45%, and the scheme administrator will deduct it before paying the lump sum to the trust.

Offsetting the special lump sum death benefits charge against income tax

Where the trust later makes a payment to a beneficiary of that trust, the gross amount of the payment is treated as income for the person’s income tax purposes. This means they can offset the appropriate amount of charge previously paid by the scheme administrator against their own tax due on the payment.

In practice, this means that if they pay income tax at a rate lower than 45%, they will be able to claim back the difference. This can be done via self-assessment or on the R40 repayment claim form.

Lump sums paid to charities

There are separate rules for payments to charities that Lisa will look at in a separate Bitesize video.

More Bitesize Technical

Get your teeth into ‘Pension death benefits – taking income, explained’ – the next instalment of our pension death benefits Bitesize Technical series.