When an individual dies with funds held within a money purchase pension scheme, there are multiple ways in which the pension benefits can be utilised by the beneficiaries. Which options are available to the beneficiaries will differ based upon the flexibility offered via the pension scheme. A lot of older schemes are not able to offer beneficiaries the full range of options available under legislation.

Following changes to legislation that became effective from 6 April 2015, the way in which death benefits can be paid, and are taxed, has changed significantly. The main ways in which death benefits can be paid are as follows:-

  • Lump Sum
  • Beneficiary’s Income Drawdown
  • Beneficiary’s Annuity
  • Scheme Pension (not as widely available as the other options noted)

There is no requirement to take the full value of the benefits under one option, i.e. take the full amount as an annuity. For example, the beneficiaries could take 50% of the value as a lump sum and allocate the balance to beneficiary’s drawdown to provide an income later in life. This is of course subject to the flexibility offered by the pension scheme.

There are many factors for the beneficiaries to consider when deciding how to utilise the benefits, such as the beneficiary’s needs, do they require an income? Or have any significant liabilities that could be cleared by a capital lump sum?

If the individual does not require the capital then the death benefits can be utilised as an effective tool for estate planning. If the benefits are retained within a pension scheme (i.e. via beneficiary’s income drawdown) and a relevant death benefit nomination is put in place, the benefits should fall outside of the beneficiary’s estate for Inheritance Tax (IHT). The pension pot could therefore remain untouched by the beneficiary and passed onto the initial beneficiaries own nominated beneficiaries without being subject to IHT.

As the beneficiary received the pension pot via a death benefit option, there are no further lifetime allowance tests and the pot can continue to grow within the tax-efficient environment.

When income is required from the pension pot, the way in which the income is taxed is dependent on the age at which the individual died. This is primarily dependent on whether the individual died pre or post age 75.

If the member died prior to attaining age 75 then any lump sums or income withdrawn will generally be paid tax-free. If the member died on or after age 75, any lump sums or income received will be taxable at the beneficiary’s marginal income tax rate. There is no lifetime allowance test as the funds will already have been tested by age 75 at the latest.

If a beneficiary who received a pension pot via a nomination subsequently dies, the taxation is based upon that individual, not the original member. For example, if a wife inherited her husband’s pension pot, and died 3 years later, leaving the pension to her son, the taxation of the pot would be dependent on the mother/wife’s age at the date of death.

There are of course many different factors to take into account when considering how to utilise death benefits from a pension plan.