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What Happens To My Pension When I Die?
This is a question that we get asked all the time. The answer is “it depends”, but in an effort to be more helpful, let’s look at the various options and their merits.
For the avoidance of doubt, I am discussing Defined Contribution rather than final salary schemes. that have not already been used to purchase an annuity at the point that the person dies. That isn’t to say that death benefits aren’t important in those cases as they most definitely are, but they are distinct and vary from the more common Defined Contribution arrangements which are most commonly held.
When people ask me what happens to their pension pot if they die, they are usually looking for reassurance that the money is not kept by the pension company should they die before using the money. This is relatively easy to tackle; the answer is that the pension provider will pay out the death benefit of the plan.
What that means can be a little more complicated, as whilst most pensions have a death benefit that is equal to the current value of the pension, some differ. Indeed, some older pensions will only pay out a return of premiums plus interest in the event of death which can often be considerably lower than the current value.
It is always therefore checking the specifics of your particular contract, but generally speaking, personal pensions established after 1988 tend to be designed so that the pension trustees (generally the pension provider) are responsible for ensuring that the pension passes to the nominated beneficiaries. As any funds coming from a pension do not form part of the deceased’s estate, there is usually no charge to Inheritance Tax. Please note, prior to age 75 there is no income tax charge on the recipient, but after age 75 this changes (discussed below).
With this knowledge, most people complete their Expression of Wish as one would expect, by naming their spouse or civil partner. Whilst on the face of it this makes perfect sense, it is often not the ideal solution.
Increasing the estate:
I have already mentioned that there is no liability for Inheritance Tax on the proceeds of pension arrangement. Likewise there is no Inheritance Tax on transfers between spouses. So how would paying your pension pot to your spouse increase Inheritance Tax?
Mr & Mrs Smith, a married couple have a total estate of £1 million in personal assets, and £500,000 each in pensions. If one of the couple dies and leaves their £500,000 pension as cash to the other, then the surviving spouse’s estate is now £1,500,000.
No Inheritance Tax has been paid, but the liability to tax on their subsequent death has no increased significantly. In my experience, this is how most people have their death benefits set up. Fortunately, there are several alternatives to this approach.
Alternative 1: Skip the Spouse/Civil Partner
Some clients are confident enough that their surviving spouse would not need any access to their pension funds that they can effectively move the funds down a generation at the earliest opportunity.
This is very effective from a tax perspective, but it does completely preclude the survivor from benefitting whatsoever. It does also mean that what may be a large sum of money is placed into an environment where it may be in the family pot for the next generation earlier than may otherwise have been planned. This can be problematic if, for example, there is a divorce at a later stage.
It is worth noting that if death occurs before age 75 there is no income tax charge on the recipient. However if the deceased was over 75, then income tax must be paid at the recipient’s highest rate.
Alternative 2: Don’t Have Cash, Have a Pension
Since 2015, there has been the option for a spouse, dependant or nominee to receive a ‘flexi-access drawdown’ arrangement, rather than a cash lump sum. This allows the recipient to inherit a pension which they can draw on at any time as they see fit. If the deceased died before age 75, then the recipient can draw down without any liability to income tax. However, if the deceased was older than 75, income tax is charged at the recipients marginal rate.
This option is therefore particularly useful if the pension owner is older than 75, as it allows the recipient(s) to control how and when they draw down the pension, which will be subject to income tax. Drawing down the value of the pension over multiple years can see a much lower amount of tax being payable than if it were paid out in one fiscal year. This type of planning should therefore be considered at the very latest as the pension owner approaches 75, although it is never too early to make good preparation.
For this option to be utilised, a couple of pieces of preparation need to be completed. Firstly, and this may sound obvious, you need to know whether the pension can allow this type of drawdown in the event of death? Many schemes simply do not allow it.
Secondly, the people who may be intended beneficiaries need to be eligible to benefit. Are they named as Nominated Beneficiaries? If your children are no longer classed as ‘dependent’ because they are age 23 or over, then they must be explicitly named to be a potential beneficiary of an inherited drawdown arrangement. The exact proportions can usually be amended after death, but if people aren’t eligible dependants or nominees then they will not be able to benefit.
There are however a couple of downsides to the Flexi – Access Drawdown arrangement. Firstly, when entering such an arrangement (after the death of the pension holder), the amount earmarked for each recipient must be determined. This can make it difficult if, for example, the surviving spouse or civil partner does not know how much of the fund they are likely to require for their own retirement.
Secondly, whilst in the event that the original member died before age 75 the recipient can withdraw the funds without any income tax, this does not mean that they are tax free forever. If the recipient lives beyond 75, then although their withdrawals remain free from income tax, upon their death the onward recipients would face income tax as the fund was derived from someone who died over aged 75.
Using the above example: Mr Smith died whilst he and Mrs Smith were both 74. Mrs Smith elects to receive a Flexi Access Drawdown plan which she can access without any income tax. Mrs Smith then subsequently dies aged 75. Her beneficiaries are now subject to income tax on any amounts taken from the pension as income.
How Else Can This be Structured?
One alternative to the cash or pension dilemma is to use a Trust. Specifically, a ‘Spousal Bypass Trust’. This is an arrangement set up before death to potentially accept death benefits from a pension for the benefit of the intended beneficiaries, whilst maintaining control and flexibility in the interim.
Upon setting up such an arrangement, Trustees are appointed to be responsible for the Trust if it is ever used. A letter of wishes can leave instruction for the Trustees, but they will retain discretion of how to benefit the recipients and when.
The Trust can invest the assets and retain as a long-term investment if desired. Whilst doing so, any assets are safeguarded from divorce as they do not explicitly belong to any of the potential recipients. A particular benefit of this is that the Trust can provide a surviving Spouse with income and capital as and when they need it, without any amount in excess of those needs forming part of their estate.
There is however a recurring theme here, and there are disadvantages to a Trust. Any investment growth within a trust is subject to tax at Trustee Rates (45% as at April 2023 – although income from the trust is distributed with a tax credit that can be reclaimed) as opposed to being tax free in a Flexi – Access Drawdown arrangement. Also, from an admin perspective, Trusts need to be registered and may need to submit tax returns and be subject to tax charges further down the line.
So what should you do with your Pension Death Benefits ?
Fortunately, it is not necessary to prescribe exactly how you wish for your pensions to be treated after your demise. All you need to do is to establish which options are available to your beneficiaries.
It is perfectly possible to state on an Expression of Wish form all potential beneficiaries that you may wish to benefit. This can be a spouse, children, grandchildren etc, but importantly all should be explicitly named, not just stated as a class of beneficiary. You can allow them to take the benefits as a lump sum or income, meaning that they can choose at the time what will suit them. You can also establish a suitable Trust which may or may not ever be used and note on your Expression of Wish that you wish for consideration to be given to using the Trust.
This may all seem very non-committal. And that is the idea. The best-case scenario is that in the event of death, the deceased has left a clear instruction to the Trustees / Scheme Administrator of their pension scheme detailing who they wish to benefit, with an Expression of Wish that enables payment to any intended beneficiary via any of the discussed means. The surviving spouse/civil partner and any other intended recipients can then be consulted as to which route is favourable for them at that stage. This also allows some future-proofing, as if you have every option open then a rule change doesn’t need a rethink. Your beneficiaries can simply choose a different option.
Caveats:
In certain instances, where income or lump sum payments would be tax-free, they can become taxable if payment is not made within two years of death.
Whilst pensions are nearly always exempt from Inheritance Tax, there are niche situations where the pensions of people in serious ill health may become subject to Inheritance Tax if certain changes are made shortly before death.
The value of an investment with St. James’s Place may fall as well as rise. You may get back less than the amount invested.
The levels and bases of taxation and reliefs from taxation can change at any time. Tax relief is dependent on individual circumstances.
Past performance is not indicative of future performance.
