Death Benefits (Defined Contribution Schemes)

How death benefits are treated for income tax purposes is dependent on two things:

  • Whether the member's death occurred before age 75 or at age 75 or over; and
  • If the member's death occurred at age 75,with either uncrystallised benefits or a lump sum death benefit paid out from crystallised benefits, whether those death benefits were paid out within the 2-year window.

The 2-year Window

This is the timeframe the trustees of the pension scheme have to pay out any death benefit, from when the member died, or when they could reasonably have expected to know of the member's death.

For those member's whose deaths occur on or after 75, there is no timescale on the payment of death benefits as all benefits are subject to income tax at the beneficiary's marginal rate of tax, or if not paid to an individual e.g. a trust or to the deceased’s estate, 45% tax is deducted.

Crystallised or Uncrystallised - does it matter?

Whether or not benefits have been crystallised is no longer a factor in terms of how any death benefit will be taxed.

The diagram below illustrates how the pension death benefits are treated depending on the age at death and the timeframe with which death benefits are paid out.



Death benefits and the Lifetime Allowance

A lifetime allowance charge may apply to benefits where:

  • The member dies before age 75; and
  • The benefits are uncrystallised (and exceed the deceased member's lifetime allowance, or personal lifetime allowance, where some form of protection was in place); and
  • the death benefit is paid out within the 2-year period; either
    • As a lump sum death benefit; or
    • Designated into a beneficiary's flexi-access drawdown

Where benefits in this circumstance do exceed the lifetime allowance there will be a lifetime allowance charge on the excess at:
  • 55% (if paid out as a lump sum)
  • 25% (if designated to flexi-access drawdown or to purchase an annuity)

If benefits were already crystallised then there would be no test aginst the deceased member's lifetime allowance.

If the benefits were paid outside of the 2-year period or the member was 75 or over when they died, these benefits would no longer need to be tested against the deceased member's lifetime allowance. However these benefits would be subject to income at the beneficiary's marginal rates or if not paid to an indvidual, for example a trust or the deceased's estate, 45% tax is deducted.
One significant change to the trules is the ability to nominate anyone as a beneficiary on death and it is no longer restricted to a dependant, normally a spouse or children of the member.

This provides more scope to plan for inter-generational estate planning. Members can now nominate anyone to inherit their pension benefits and those nominees in flex-access drawdown can also leave any remaining benefits to a successor on their subsequent death.

From a tax perspective, how these benefits are treated is determined by the age at death of the last persion to be in control of them. So, for example, where benefits are to be designated to a beneficiary's flexi-access drawdown, this would be the member initially, then either a dependant or nominee, followed by subsequent successors. Therefore these benefits have the potential to fall in and out of tax for HRMC purposes.

For example, if the member dies on or after their 75th birthday and they nominate their spouse to receive their flex-access drawdown benefit, this benefit will be taxable at their spouse's marginal rate. However, if the spouse then dies before they reach age 75 their nominated successor would then receive this benefit tax-free and so on.

tax benefits and tax status of beneficiary following deceased pension plan
  • Setting up a bypass trust for pension lump sum benefits
  • Using the benficary's FAD in an IHT efficient manner
  • Using existing wealth to build up other family members retirement position
  • Running down other non-pension assets to provide income in retirement
  • Taking and investing any tax-free cash at age 75 outside of pensions

 

This briefing note is also available as a PDF document.

Please note that we are providing this information and comment based on our current understanding of tax law, HMRC practice and legislation which may change and it should not be considered a definitive statement in law. We are also providing this on the strict basis that they are for your consideration only and that ultimate responsibility for any advice given to your client lies with yourself. Canada Life and Canada Life International Limited cannot be held responsible for the results of any action or inaction the client may undertake.  

 

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