Planning ahead: pension death benefits and upcoming IHT changes

Understanding what happens to pension savings after death is a crucial part of financial planning. With significant changes to the tax treatment of pension death benefits coming up, it’s important to stay informed.

Who can receive pension death benefits?

Pension death benefits can be paid out to any individual or an entity such as a trust or charity. Only an individual defined as a “beneficiary” can take the pension death benefits as income. Beneficiaries must either be a “dependant”, a “nominee” or a “successor” to be eligible for pension income. A “dependant” of the deceased member is automatically eligible to be a beneficiary, this includes spouses, civil partners, children under 23, or anyone financially dependent or interdependent on the member. The pension member can nominate anyone else they wish to be a “nominee”. The scheme administrator can also make a nomination, but only where there are no surviving dependants of the member, and the member made no nomination. When a beneficiary dies, their beneficiary’s funds can be passed on again to “successors”. A “successor” must be nominated by the beneficiary who last had the funds, or if no nomination has been made, then the scheme administrator can make a nomination. Beneficiaries have the option of taking the pension death benefits as a lump sum, using it to purchase an annuity, designating the funds to provide them with an income in the future, or a combination of all three.

Discretion

For most defined contribution pensions the trustees have discretion in deciding who receives the pension death benefits. The trustees will always consider the needs of any dependants, whether they have been nominated by the deceased or not. The trustees will consider any expression of wish, changes to circumstances and ask questions to identify the potential beneficiaries. Anything written in a Will cannot bind the trustees, however it can contain relevant information to help the trustees exercise their discretion. There is no right or wrong answer when exercising discretion, but the trustees must make a decision that is reasonable, has considered all the relevant factors and disregarded irrelevant factors.

Under current rules, the ability to exercise discretion ensure that most pension benefits are not included in the deceased’s estate. Discretion is also important when expression of wishes have not been completed, or are out of date and no longer appropriate.

Current tax rules

Where the pension member dies before the age of 75 and the beneficiary takes the death benefits in the form of a pension income, there is usually no charge to income tax, and no limit on the amount that can be passed on tax-free. If the member dies before age 75 and the death benefits are paid as a lump sum, then the maximum amount that can be paid tax-free is capped at the deceased’s available lump sum and death benefit allowance (LSDBA). For most people this is £1,073,100 less any tax-free lump sums taken in their lifetime. Any lump sum paid above the available LSDBA will be subject to income tax.

Where the pension member dies on or after their 75th birthday the death benefits will be subject to income tax, regardless of how they are taken. Charity lump sum death benefits can be paid without limit free of tax if the deceased had no dependants and they had nominated the charity in their lifetime.

Tax rules from 6 April 2027

It is proposed that pensions will be included in the estate for inheritance tax (IHT) purposes where a pension member dies on or after 6 April 2027. The legislation to implement this is still draft, the consultation on this has now closed but no response has yet been issued. We expect the legislation to be included in the Finance Bill due out approximately around the start of December.

HMRC have confirmed that exemptions apply to transfers to spouses or civil partners, to dependant’s scheme pension, death-in-service benefits, payments to charities and registered clubs, and to joint life annuities. All other pension death benefits are to be included in the estate for IHT purposes. IHT will apply to the pension death benefits if they don’t meet any of the exemptions, and the deceased’s nil rate band has been used. IHT will be calculated first, then the residual fund will be subject to income tax if applicable (depending on how old the member was when they died).

Personal representatives (PRs) will now be responsible for paying the IHT to HMRC on the pension element, as well as for the rest of the estate. PRs can choose to pay the IHT from the free estate or ask the pension beneficiaries to pay it direct to HMRC. When a PR has requested the beneficiary pays IHT to HMRC, the beneficiary can instead direct the pension scheme administrator to pay it out of the pension. Where the beneficiary has paid the IHT themselves, or receive a smaller share of the estate because the IHT relating to the pension has first been deducted, and there is income tax payable on the pension death benefits, they can request an income tax refund on the income received from the pension that would have not had been subject to income tax had the IHT been paid direct.

Want to know more?

We’ve summarised the main takeaways here, but there’s more to explore. The full webinar with our Senior Technical Consultant, Lisa Webster, provides further commentary on:

• Who can receive pension death benefits?
• Discretion
• Current tax rules
• Tax rules from 6 April 2027

Watch the webinar on demand here.