A pension plan is a very tax-efficient way of saving money for later in life. However, some of you may die before you can fully utilise your accumulated benefits. What are the key tax considerations in these circumstances?
Pension payments generally
For inheritance tax (IHT) purposes, an individual’s estate is made up of the aggregate of their assets and liabilities. It is the starting point when calculating the IHT payable and the amount available to pass on to others following the death of the individual. Should the individual reduce their estate during their life, for example by giving away an asset, this will generally be considered a potentially exempt transfer (PET), subject to various exemptions (see Follow up).
Pro advice. PETs may be brought back into an individual’s estate if the transferor’s death occurs within seven years of the transfer. These are known as “failed” PETs, and use up any nil rate band in priority to other assets.
Payments by an individual to their own pension plan will not usually be PETs, as they will later benefit from the plan and so there is, effectively, no change to their net estate. The exception to this is where the individual is in ill health, as detailed below.
Pro advice. This is not the case where payments are made to another person’s pension plan, unless an exemption applies such as where the payment is between spouses.
Death before full enjoyment
What happens if you don’t benefit from the plan, as you die before fully exploiting the invested funds?
Often another party can inherit some or all of the remaining pension pot and sometimes even the in-progress pension payments themselves (or a percentage of them). Pension payments received will generally be taxed on the recipient as additional income, but the income tax treatment for lump sums will depend on the age of the individual when they die.
Provided payment is at the discretion of the pension provider, these lump sums are free of IHT.
Pro advice. The remainder of this article refers to the persons receiving payments from the deceased’s pension/pot as “inheritors”. These are not necessarily the same people as the beneficiaries named in the will and must be specified to the scheme provider separately.
Defined contribution schemes
Where an individual purchases an annuity from a defined contribution (DC) scheme, there is generally no pot to inherit, although certain annuities allow a spouse or other person to receive income after the individual’s death, often for a fixed period. Such policies are often termed as “joint life annuities” or annuities with a “guarantee period”.
Pro advice. An annuity is where the individual uses some or all of the pension pot to purchase a steady income for the remainder of their life, hence why there is potentially nothing for someone else to inherit.
Any ongoing pension provided by the scheme will be taxed as additional income of the inheritor.
Defined benefit schemes
In a similar vein, defined benefit (DB) schemes generally do not have a pension pot to inherit. However, some plans allow a spouse or dependant to benefit under certain conditions; this should be discussed with the scheme provider. Any inheritor(s) will receive a lump sum and/or a continuing income on death, the latter usually being a proportion of the amount the deceased was receiving/would have received during their life.
Pro advice. A DB scheme is also known as a final salary scheme. Under such a scheme, the taxpayer is guaranteed a fixed income following their retirement and makes lifetime payments accordingly.
Again, any ongoing pension provided by the scheme will be taxable income for the inheritor.
Remaining DC pot
For DC schemes, an individual does not have to use their entire pension pot at retirement, they may instead choose to take a lump-sum cash amount, drawdown ad hoc amounts over time, or use a proportion of their pot to purchase an annuity. Any amount remaining in the plan can be passed to another person on death.
As mentioned above, the income tax treatment of this inherited pot will depend on the age of the individual when they die, as follows.
Death before the age of 75
Subject to the below, the inheritor of a lump sum from a pension fund will not pay any tax, provided the deceased was under the age of 75 when they died. To be free of tax, the money must be paid to the inheritor within two years of the earlier of:
- the date on which the pension scheme administrator was first made aware of the death; and
- the date the administrator could reasonably have been expected to have been aware of the death.
Pro advice. This can be a very powerful IHT planning tool, i.e. using cash or other liquid assets (which would attract IHT) to meet costs of living in priority to pension funds.
Death on or after the age of 75
If the individual dies on or after their 75th birthday, then any lump sums taken will be taxed at the inheritor’s marginal rate of tax at the point they receive the payment (or payments in the case of a drawdown).
Pro advice. Further details regarding the tax treatment of pensions for deaths before/after the age of 75 can be found on GOV.UK (see Follow up).
Ill health
As mentioned earlier, payments to a pension plan will usually not count as PETs and so will not factor into the IHT calculation on death.
However, certain payments made while the individual is in “ill health” may be regarded as transfers of value and so the payments would potentially be added back to the estate on death. Such payments could include contributions into the individual’s pension plan, as well as the transfer of benefits from one plan to another.
HMRC’s argument is broadly that if at the time of the contribution/transfer the individual knows they will not benefit from the plan, any money paid into it should remain in their death estate.
Pro advice. HMRC generally accepts that anyone who survives for two years after the payment/transfer was not in ill health at that date for these purposes. Even if HMRC wishes to enforce this rule, an argument can potentially be made that the death was not expected when the payment/transfer occurred.
The state pension
Where a couple married or became civil partners before 6 April 2016, it may be possible for a surviving partner to inherit part of the deceased’s state pension.
Depending on the date of death and the date the deceased partner reached state pension age, or would have had they not died, the surviving partner may inherit part of either the additional state pension or the protected payment.
Any inherited state pension element is taxable income for the inheritor.
By leaving part of your pension pot undrawn, if you die before your 75th birthday you can pass money to your chosen beneficiaries free of income tax and inheritance tax (IHT), as opposed to cash you have either drawn or taken as an annuity which could be liable to IHT as part of your death estate. A double bonus is that using cash or other assets to fund the cost of living instead of a pension reduces the taxable estate as well.
Follow up
Further information regarding treatment of pensions pre/post 75th birthday
Guidance on exemptions to PETs
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.