Drawdown Pension and Death Benefits

Although we all appreciate the importance of paying into a pension for our own retirement, fewer of us have an understanding of what happens to our savings once we’re gone. If you’re wondering if a drawdown pension can be inherited and how drawdown pension death benefits actually work, then you are definitely not alone.

In this article we look specifically at what happens to your drawdown pension when you die, how the situation changes depending on your age and what the tax liabilities will be on your death benefits.

What happens to your drawdown pension when you die?

Since the government made changes to pensions in 2015, there is a lot more flexibility around how funds are taken out and how they can be passed on. If you’ve opted to take a flexible income from your pension and are in drawdown when you die, your beneficiary (or beneficiaries) has a few options.

The first is to take the money as a lump sum. They can use this for whatever purpose they like, including using the cash to purchase an annuity, giving them a fixed, regular income. Alternatively they can choose to do nothing for now and keep the money invested, or they may be able to set up a flexi-access drawdown plan. Not all schemes offer pension drawdown for beneficiaries, but they may be able to transfer to another scheme to do this.

These same options apply whether we’re talking about a flexi-access drawdown plan or capped drawdown death benefits.

When it comes to how drawdown pension death benefits are taxed, this depends on your age at death, and how quickly funds are accessed.

Tax on drawdown death benefits pre 75

If you die before the age of 75, your beneficiaries can inherit any remaining pension funds tax free, as long as the money is paid out to them within two years. Technically the two year period is not two years from the date of your death, but two years from the earlier of either the date the scheme administrator knew about your death, or the date they could reasonably be expected to know about it.

If the money isn’t taken within this two year period then the death benefits are treated as income for tax purposes, and will be taxed at the beneficiary’s marginal rate.

It is important to note that death is classed as a benefit crystallisation event. This means that if your pension benefits exceed your lifetime allowance on death, there will be a lifetime allowance charge applicable to the excess. How much is applied depends on how your beneficiary takes the income from your pension.

Tax on drawdown death benefits after 75

If you die after the age of 75, all death benefits are subject to income tax, paid at the beneficiary’s marginal rate. As reaching age 75 is considered a benefit crystallisation event, there are no further tests against the lifetime allowance at this stage.

Who can inherit your drawdown pension?

It’s up to you who inherits your pension. It could be one person, such as a spouse or child, multiple people, or even a charity. You can nominate who you would like to inherit your pension by filling out a form via your pension provider, normally called a ‘nomination of beneficiaries’ form or an ‘expression of wish’ form. Most people nominate a beneficiary when they first take out a pension, and then forget about it, so make sure you keep this up to date.

Funds held in your pension scheme are not considered as part of your estate on death and are therefore exempt from inheritance tax. Although the scheme administrators or trustees will normally honour your wishes, they are not legally obliged to do so. For example, they may make a discretionary lump sum death benefit payment to someone else if the nominated person cannot be found or has died.

If you’re at all unclear on who can inherit your pension and how it works, get in touch to speak to an advisor.

Remember: your pension doesn’t form part of your estate, so you cannot nominate someone to inherit your pension in your will. Beneficiaries must be arranged through your pension provider.

Do I pay inheritance tax on pension death benefits?

No, as long as your pension scheme administrator has discretion over who the benefits are paid to, pension death benefits are not usually liable for inheritance tax. If you want to be completely clear on how inheritance tax might apply to your own pension, or have very specific needs in terms of how your beneficiaries are set up, then get in touch and we can arrange a free chat with an independent pensions advisor.

Do pension death benefits affect your lifetime allowance?

Yes, in some circumstances. Unfortunately any charges for exceeding your lifetime allowance will not be automatically written off when you die, and so it’s important for your beneficiaries to be aware of them.

A lifetime allowance tax charge will be due on death if all of the following conditions apply:

• You are under 75 when you die
• Funds are paid out within two years
• You have exceeded your lifetime allowance

There is no lifetime allowance test if you die after age 75 as your funds will automatically be tested when you reach age 75. If your funds are not paid out within 2 years, they will not be tested against the lifetime allowance, but they will be taxed at your beneficiaries marginal income tax rate.

If your beneficiaries decide to take the funds in the form of flexi-access drawdown death benefits or to buy an annuity, any charges will be applied at 25%. For lump sums, it’s 55%. It’s important to note that it is the responsibility of the executor, not the scheme administrators, to carry out the test.The only exception to this would be for ‘crystallised’ pension funds – in this instance no tax charges would apply (only uncrystallised funds are taken into account).

If you inherit a pension, the value of the inherited fund does not count towards your own lifetime allowance.