Pension death benefits: planning options and tax considerations

There can be a valuable ‘pot’ remaining in a pension on the death of the member. The use of this pot can necessitate some careful planning. Appropriate lifetime planning will depend on the type of pension, the level of discretion and the identity and circumstances of the potential beneficiaries. There are several relevant factors that need to be considered.

What are pension death benefits?

Pension death benefits refer to the payments or benefits that are available from a pension pot to provide benefit to beneficiaries after the death of the member.

How does the type of pension affect what's available?

Defined benefit plans

• These types of plan don't have a designated ‘pot’ per pension member but rather guarantee a specific monthly payment to retirees, based on a formula considering factors like salary history and years of service. These monthly payments are paid out of a pooled pot.
• If the member dies before retirement, the plan may offer a death benefit to certain beneficiaries. This could be a lump sum or an annuity, depending on the plan’s rules.
• If the member dies after retirement, the benefits available to the beneficiaries depend on the options chosen at retirement. For example, if the member selected a joint-and-survivor annuity, the surviving spouse would continue to receive a portion of the pension.
  • There isn't an individual pot of money that gets passed on, but rather a continuation of the promised benefits under the plan's terms.
• If there's no designated beneficiary or qualifying spouse, the benefits may revert to the plan or be paid to the member's estate, depending on the plan's specific provisions.  
• The member can nominate certain individuals to benefit on their death, as specified by the scheme rules. In many plans, the final decision on the provision of benefit is at the discretion of the pension trustees. However, there are some defined benefit plans, such as NHS pensions, which are paid to the estate of the deceased member and distributed according to their Will or intestacy.

Defined contribution plans

• These plans are generated by contributions from the member (and, in some circumstances, by an employer) into a personal pension ‘pot’. The retirement benefit due to the member depends on the investment performance of their particular pot.
• On the death of the member, the remaining balance in the account is available to provide benefit to certain beneficiaries. This benefit can be in the form of a lump sum or rolled over within the pension environment and drawn down as a continuing pension income by the beneficiary. 
• In theory, the member can nominate anyone as a beneficiary and does so with an ‘expression of wish’ form. This will allow the pension trustees to consider those individuals to receive a potential benefit. If the member hasn't nominated anyone, the pension trustees have a restricted class of individuals who they can consider for benefit. Inclusion in this class depends on a legal relationship with the member and, in some cases, on age and dependency. If an individual hasn't been nominated by the member and isn't within the prescribed class, the pension trustees are unable to consider them as recipients.
• Ultimately, the provision of benefit from the unused pension pot is at the discretion of the pension trustees, but they will consider the member’s wishes and the relevant circumstances at the time and should consult with the potential beneficiaries.
  
  

What are the options for payment of a death benefit under a defined contribution plan?

Depending on the terms of the plan, there may be different options to consider:

Lump-sum distribution 

• The entire account balance is paid out in one single payment.
• Depending on the member’s ‘expression of wishes’ and the plan rules, it may be possible to pay directly to an individual/individuals or to a family trust. The latter can provide continued benefit to a discretionary class in a protective and flexible manner.

Annuity payments 

• The beneficiary receives regular payments over a specified period or for their lifetime.

Drawdown

• The beneficiary can withdraw funds as a pension income, as needed, allowing the remaining balance to continue growing efficiently within the pension pot.

Combination 

• Some plans allow a mix of the above options, providing flexibility to the beneficiary.
  
  

How are pension death benefits taxed?

If the member dies before age 75

Income Tax - Whether or not the beneficiary takes a lump sum or continues in drawdown, the pension death benefits can be accessed free from income tax.

Inheritance Tax - The majority of pension funds are currently outside the member's estate for IHT purposes but this is set to change on 6 April 2027, when it is planned that any unused pension pot will be subject to inheritance tax as if it were part of the estate of the member. See below for more information.

If the member dies after age 75

Income Tax - When a beneficiary takes a benefit from the pension pot (whether as a lump sum or as a continuing pension income) they will pay tax on the benefit at their own marginal rate of income tax.

Some potential beneficiaries may have lower tax rates or more personal allowances than others, which will make a payment to those beneficiaries more tax efficient. Payment to a family trust will generate an income tax charge at the highest rate, currently 45%.

Inheritance Tax - The majority of pension funds are currently outside the member's estate for IHT purposes but this is set to change on 6 April 2027, when it is planned that any unused pension pot will be subject to inheritance tax as if it were part of the estate of the member. See below for further information.

Summary of the planned changes to bring unused pension pots to Inheritance Tax

From 6 April 2027, the following changes are planned:

What's the impact of this change for pension death benefit planning?

If a member, over the age of 75, dies after 6 April 2027 and the pension trustees use their discretion to pay the pot to a non-exempt beneficiary, who is also a higher rate taxpayer for income tax purposes, the effective rate of tax for accessing the funds will be up to 67%.

Whether the funds are then left within the pension environment or paid out, any unused funds could then be taxed to inheritance tax as part of that recipient’s estate in due course.

However, this is a worst-case scenario and careful planning by the original member and the recipient of the death benefits could significantly mitigate the tax implications.  

It is very difficult to predict what the ‘best’ option will be at the relevant time. The most appropriate use of an unused pension pot on the death of the member may depend on the following:

1. On whether the member dies before or after 6 April 2027
2. On whether they were over or under the age of 75 at the time of their death
3. On the circumstances of the possible beneficiaries, including:
   (a) their age and life expectancy
   (b) their marginal tax rates
   (c) whether they ‘need’ the funds or could afford to do some lifetime tax planning
   (d) whether they are exempt beneficiaries for inheritance tax purposes

As a result of these uncertainties, flexibility is crucial.

What should pension members do now?

1. Speak to their wealth advisers about their general pension strategy
2. Consider lifetime gifting options with any unused pension ‘tax free cash’ or any pension income not required for maintenance. There may be inheritance tax efficient options to consider.
3. Ensure that their pension ‘expression of wish’ forms are up to date and include flexible options and requests to consult appropriate parties before exercise of any discretionary powers.

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