Planning for the future is crucial, but it's equally important to understand what happens to your investments after you're gone. In our 'Investments Beyond Life' series, we'll be covering what happens to your assets when you pass away.
In the first blog of this series, we'll delve into what happens to your pensions after you pass away, ensuring you are well-informed about tax implications, inheritance laws, and financial planning options.
Tax treatment
The tax treatment of defined contribution (money purchase) pensions on death is subject to several factors, including the age of the pension member and the type of payment.
Inheritance Tax (IHT)
Most pension schemes are written in a Discretionary Trust and therefore they are outside of the member's estate for IHT purposes. If the pension benefits are distributed within 2 years of member's death, there is typically no IHT payable.
There are, however, some important things to consider: some older pension contracts offer a 'return of fund' only which means that in the event of death, the scheme Trustees will pay out the pension value to the member's nominated beneficiary(ies) as a lump sum payment which could result in a future IHT liability. If, for example, the recipient is a surviving spouse who does not spend or gift the funds in full, in the event of the spouses' death, the pay-out from the pension would be in their estate and that capital would be subject to IHT.
More modern contracts allow pension death benefits to remain within the tax-privileged pension environment, which provides the recipients with complete flexibility over how and when they access the inherited pension. They can also nominate their own beneficiaries to receive any remaining funds on their death.
Keeping an up-to-date Expression of Wish or nomination form is crucial and allows members to indicate who they would like to nominate as the beneficiary(ies) to receive their death benefits.
Income tax on lump sums
- Death before age 75: The pension fund can pass tax-free to any person, including a Trust, if it's within the available Lump Sum and Death Benefit Allowance (LSDBA) of up to £1,073,100. Any excess is taxed at the beneficiary's marginal rate (or 45% if going into Trust).
Beneficiaries must be designated within two years of the earlier of; the day the scheme administrator first knew of the member's death, or the day they could first reasonably have been expected to know of it for the favourable tax treatment; otherwise, lump sum payments are taxed at the recipient's marginal rate.
- Deaths from age 75: The pension fund can be passed to any beneficiary, who will then pay income tax at their marginal rate on withdrawals. A 45% tax charge applies if the benefits are paid as a lump sum to a trust.
Income tax on drawdown income
- Death before age 75: Income payments can normally be paid tax-free. For payments from untouched (uncrystallised) pension funds, beneficiaries must be designated within two years for the favourable tax treatment; otherwise, lump sum payments are taxed at the recipient's marginal rate.
- Death from age 75: All income payments are taxable at the beneficiary's marginal rate. The tax treatment of inherited drawdown income depends on the death of the last owner. Therefore, funds that are cascaded down generations can be taxed differently depending on whether the last owner died before or after age 75.
Inherited annuities
If an individual dies before age 75 with a joint life or guaranteed term annuity, beneficiaries can receive payments tax-free. However, if the individual dies at age 75 or older, beneficiaries will pay tax at their marginal rate on the income.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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