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Pension defined contribution scheme death benefits

Introduction

This briefing sets out the death benefits that a defined contribution scheme can pay and the tax treatment of those benefits. It looks at the lump sum and income options along with the benefits of pension protections.

Core considerations  

  • Defined contribution scheme death benefits can be paid as a lump sum or pension income and may comprise a number of different types of payment.  

  • In most cases pension scheme death benefits (whatever their form or timing) are free of IHT because the trustees or scheme administrators have a choice over who they pay.  

  • Lump sum death benefits payable for a member who dies under age 75 are tested against the lump sum and death benefit allowance (LSDBA). Lump sums are tax free within the LSDBA, any excess is taxed as income of the beneficiary(ies).

  • Multiple lump sums will each be allocated a proportion of the available LSDBA. 

  • Death benefits payable as income (annuity or drawdown) are not tested against the LSDBA.

  • All payments made on the death of a member on or after age 75 are taxable as income of the recipient and are not tested against the LSDBA. 

  • Lump sum benefits payable in respect of funds already drawn (crystallised) before 6 April 2024 do not need to be tested against the LSDBA. 

  • Individuals with pension protection benefit from a higher LSDBA.

Contents


Defined contribution scheme death benefits

Defined contribution (DC) scheme pension death benefits fall into two categories, a lump sum or an income, and can be paid from either crystallised or uncrystallised benefits. Any combination of benefits can be paid from a scheme providing the scheme rules allow. Some products, pension schemes or providers may not be able to offer beneficiary drawdown or annuities, and few allow scheme pensions. 

Death benefits from most pension schemes are held outside of the estate and the scheme trustees have discretion over who to pay.  

Most pension death benefits are paid to dependants or nominated beneficiaries of the deceased member. Any individual that is chosen to receive pension benefits usually has a choice how to receive the benefits. These individuals are sometimes referred to as ‘qualifying persons’. 

Alternatively, death benefits may be paid to a ‘non-qualifying person’ such as the trustees of a trust or the legal personal representatives of the estate of the deceased. Non-qualifying persons are only able to receive a lump sum, and cannot select any form of drawdown, annuity or scheme pension. This could restrict possible tax planning options. This is why it is important to nominate all possible beneficiaries.
 

Death benefits and inheritance tax

Currently, there should be no inheritance tax (IHT) payable on most pension death benefits, though the IHT exemption relies on the scheme administrator having final discretion in the choice of beneficiary. The member can typically nominate who they wish to receive the death benefits.

In the Autumn Budget 2024 the Government announced a consultation to bring unused pensions and pension death benefits into assessment for inheritance tax from April 2027.

The consultation is looking to remove:

  • the incentive to use pensions as a tax-planning vehicle for wealth transfer after death. 
  • the distinction between how discretionary and non-discretionary death benefits will be taxed. 

In addition to assessment to IHT, the residual benefits may also be liable to income tax at the beneficiary’s marginal rate as detailed below.


What are the death benefit options?

What can be paid on death in a defined contribution arrangement depends on what the scheme rules allow, what the provider offers, and the current state of the pension benefits.

All benefits are considered paid at the same time, even if paid to multiple beneficiaries. This is important to consider when determining which beneficiaries will be liable to tax, and how much tax if they receive lump sums that exceed the lump sum and death benefit allowance. 

1.    Death with uncrystallised funds   
       It is possible for one or more of the following benefits to be paid:

  • an uncrystallised funds lump sum (see below for more information)
  • a dependant’s/nominee’s annuity
  • a dependant’s scheme pension
  • beneficiary’s flexi-access drawdown

      In specific relevant circumstances a charity lump sum benefit might be paid.

2.    Death with a drawdown pension
       
It is possible for one or more of the following benefits to be paid:

  • a beneficiary’s drawdown/flexi-access drawdown pension fund lump sum 
  • a dependant’s/nominee’s annuity
  • a successor’s annuity
  • beneficiary’s flexi-access drawdown

       In specific relevant circumstances a charity lump sum death benefit might be paid.  

3.    Death while in receipt of a secured income
       It is possible for one or more of the following benefits to be paid:

  • an annuity protection lump sum (only if purchased when the annuity was bought)
  • a dependant’s/nominee’s annuity
  • a dependant’s scheme pension

       In specific relevant circumstances a trivial commutation lump sum death benefit might be paid.  
 

Death benefit lump sums

There are a number of lump sum death benefits that could be payable from a defined contribution scheme.Only lump sum death benefits payable on or after 6 April 2016 are considered here – the rules were different for payments before that date. All pension scheme death benefit lump sum options are set out in detail in HMRC’s Pensions Tax Manual section PTM073000. Anything paid outside these rules would be an unauthorised member payment and taxed as such. 


Uncrystallised funds lump sum death benefit

Pension schemes can pay an uncrystallised funds lump sum death benefit from any unused pension fund, these being funds that have not converted to drawdown or purchased an annuity. The lump sum can be paid to individuals or non-qualifying persons.

If the member was aged under 75 at the date of death this lump sum must be tested against the available LSDBA. The following table sets out the tax treatment of the payment. 

Benefit Paid to individual Paid to non-qualifying person
Lump sum within LSDBA and settled within 2 years of notification Tax-free Tax-free
Lump sum in excess of LSDBA and settled within 2 years of notification Taxable at beneficiary’s marginal rate Taxed at basic rate, or the trust rate of 45% to a trust
 
Lump sum not settled within 2 years of notification Taxable at beneficiary’s marginal rate Taxed at special lump sum death benefit charge at 45%

Where a member dies on or after age 75, the lump sum is taxable even if there is remaining LSDBA. Any payments to an individual are taxed at the beneficiary’s marginal rate. Any payments to non-individuals are subject to the special lump sum death benefit charge of 45%.

 

Drawdown/flexi-access drawdown lump sum

A drawdown/flexi-access drawdown lump sum death benefit can be paid where the member (or the dependant/successor) held remaining funds in a drawdown or flexi-access drawdown arrangement at the date of death. The removal of the lifetime allowance creates two tranches, which have different taxation as shown below:

1. Fund converted to drawdown before 6 April 2024

There is no check against the deceased’s available LSDBA, the drawdown benefits were already tested against the lifetime allowance. On death before age 75, lump sums paid from these funds are paid tax free to both individuals and non-qualifying persons.

However, where a member dies on or after age 75, the lump sum is taxable. Any payments to an individual are taxed at the beneficiary’s marginal rate. Any payments to non-individuals are subject to the special lump sum death benefit charge of 45%.
 

2. Fund converted to drawdown after 5 April 2024

Where the member was aged under 75 at the date of death a check against the LSDBA will be required and the following table sets out the tax treatment of the payment. 

Benefit

Paid to individual Paid to non-qualifying person
Lump sum within LSDBA and settled within 2 years of notification Tax-free Tax-free
Lump sum in excess of LSDBA and settled within 2 years of notification Taxable at beneficiary’s marginal rate Taxed at basic rate, or the trust rate of 45% to a trust
Lump sum not settled within 2 years of notification Taxable at beneficiary’s marginal rate Taxed at special lump sum death benefit charge at 45%
 

Regardless of when the pension benefits were converted to drawdown, where a member dies on or after age 75, the lump sum is taxable even if there is available LSDBA. Any payments to an individual are taxed at the beneficiary’s marginal rate. Any payments to non-individuals are subject to the special lump sum death benefit charge of 45%.

 

Trivial commutation lump sum death benefit

A trivial commutation lump sum death benefit could be paid if a dependant or beneficiary has an entitlement to a small dependant’s or member’s pension which continues to be paid under a pension guarantee.

Where the value does not exceed £30,000 the individual can take a lump sum rather than a continuing pension. A trivial commutation lump sum death benefit is not tested against the LSDBA because it is not regarded as a relevant benefit crystallisation event. The lump sum is taxable as pension income of the person who receives it. The scheme administrator must apply PAYE to the lump sum payment before paying it.
 

Annuity Protection lump sum death benefit

Where a member starts to receive a scheme pension from a defined contribution scheme, or a lifetime annuity, they may choose to guarantee the amount that will be provided. If the member dies before the guaranteed amount has been paid the balance can be paid as an annuity protection lump sum death benefit. If the guarantee is not purchased when the income is secured, then an annuity protection lump sum cannot be paid. 

Such a payment is not tested against the LSDBA because it is not regarded as a relevant benefit crystallisation event.

If the member was aged under 75 at the date of death this lump sum is not taxable. If the member was aged 75 or over at the date of death the lump sum is taxable as income of the recipient. If the recipient was a non-qualifying person the special lump sum death benefit charge of 45% will apply.
 

Charity lump sum death benefit 

A charity lump sum death benefit can be paid to a charity nominated by the member provided there are no dependants when the death benefits are paid. A charity lump sum death benefit can also be paid on the death of a dependant, nominee or successor, providing the charity was nominated. It can be paid from any remaining drawdown or uncrystallised funds. The charity must be one that meets a prescribed definition, and the scheme administrator cannot choose the charity it pays to.

A charity lump sum death benefit is not a relevant benefit crystallisation event so does not trigger a LSDBA test, nor is there any other tax charge to pay by the scheme administrator or the receiving charity (provided it used for charitable purposes). 
 

Multiple lump sums and the LSDBA

Where multiple lump sums are paid on death, whether from the same scheme or different schemes, the payment of the lump sums is considered to happen simultaneously, even when they are settled at different times. As a result, the relevant proportion of the available LSDBA for each payment needs to be calculated, as follows:
 

Example of available LSDBA x lump sum

Rosie died age 68 with £1m in a SIPP nominated equally to four children, Adam, John, Sophie and Lilly. The scheme trustees used their discretion and chose to pay in line with the nomination. Adam, John and Sophie took their share of the benefits as a lump sum, and Lilly took her share as a beneficiary drawdown. Rosie had £600,000 remaining LSDBA when she died. 

Lilly will have £250,000 allocated to a beneficiary drawdown, as this was not paid as a lump sum, it means the lump sums paid total £750,000. 

Adam, John and Sophie receive a lump sum of £250,000 each, so the relevant proportion of the LSDBA available for the lump sum for each of them is:

£600,000 x £250,000 /£750,000 = £200,000

Adam, John and Sophie will each receive £250,000 but will each have to pay income tax on £50,000. 


Until all the death benefits have been taken it won’t be clear how the LSDBA will be proportioned. Therefore if the total pension value exceeds the available LSDBA it may not be clear until benefits have been taken to know how people may be taxed. 
 

Example of total lump sum death benefits

If we continue the above example. If Adam and John took lump sums immediately, but Sophie settled her lump sum 18 months later (still within the two-year period), then the proportion of the LSDBA available for Adam and John won’t be known until Sophie decided how to take her benefits. If Sophie took her benefits as drawdown, then there would be sufficient LSDBA so that Adam and John are not taxed, but as she received a lump sum then the LSDBA is proportioned across the three lump sums. As a result, a tax charge could come some time after receiving the initial lump sum. 

 

Death benefit income options

There are a number of pension death benefit income options that could be payable from a defined contribution scheme. The options are set out in detail in HMRC’s Pensions Tax Manual section PTM072000. Anything paid outside these rules would be an unauthorised member payment and taxed as such.

Since April 2015 pension income can be provided to a dependant, nominee or successor.

The definition of a dependant is set out in HMRC’s Pensions Tax Manual PTM071200. The definition broadly includes a spouse or civil partner, a child under the age of 23 or mentally or physically impaired, or someone financially dependent on the member. The definition of a nominee and a successor is set out in HMRC’s Pensions Tax Manual PTM073100.   

Death benefits payable as income are not tested against the lump sum and death benefit allowance.
 

Dependant’s/nominees annuity

A dependant’s/nominee’s annuity can only be purchased from an insurance company using funds held under a defined contribution arrangement. This could happen during the member’s lifetime as a related annuity to the member’s or after death of the member using remaining uncrystallised funds, drawdown pension funds or flexi-access drawdown pension funds. This includes funds from a dependant’s or nominee’s own drawdown fund.

The annuity must be payable until the dependant or nominee dies but it can stop earlier if they marry or enter a civil partnership. Such an annuity for a child must usually stop when the child ceases to be dependant (usually at age 23 unless the dependency is due to mental or physical impairment).

If the member was under age 75 at the date of death, a dependant’s/nominee’s annuity setup within the two-year window will be tax free.

If the member was age 75 or over at the date of death, or if the annuity is not setup within the two-year window, then the dependant’s/nominee’s annuity income will be taxable as pension income.

A successor’s annuity can only be purchased from an insurance company following the death of a dependant, nominee or other successor. This could arise in relation to any funds remaining in a beneficiary’s flexi-access drawdown or dependant’s drawdown pension fund. The taxation of a successor annuity is the same as set out above for a dependants/nominees annuity.
 

Beneficiary’s flexi-access drawdown

A beneficiary’s flexi-access drawdown (FAD) pension can be provided to a dependant, nominee or successor. It can comprise both a short-term annuity and income withdrawal and can only be paid from defined contribution arrangements.

Funds are designated to the beneficiary’s FAD following the death of the member or a previous dependant, nominee or successor. There is no upper or lower age limit for paying a beneficiary’s FAD.

The tax treatment depends on the age of the member when they die, the form of the benefits and whether the two-year rule applies. The below table sets out the tax treatment. 

Form of existing benefits Death before age 75 Death after age 75
Unused uncrystallised benefits Paid tax free if designated to drawdown within two years Drawn benefits are subject to income tax at
beneficiary’s marginal rate
 
Drawdown benefits Paid tax free Drawn benefits are subject to income tax at
beneficiary’s marginal rate

Withdrawals from a successor’s FAD in respect of a dependent, beneficiary or successor who died under age 75 are tax free. Death after age 75 means any successor FAD withdrawals will be taxable as pension income.

With a beneficiary’s short-term annuity, some of the beneficiary’s FAD funds will be used to buy an annuity contract from an insurance company. The annuity contract will pay the beneficiary certain income each year for a fixed period of up to five years and cannot provide a benefit after the beneficiary’s death.

Payments from a beneficiary’s short-term annuity are treated for tax purposes in the same way as withdrawals from a beneficiary’s FAD.

A dependant’s drawdown pension could still be in place if it started before 6 April 2015 and there have been no events since that date resulting in its conversion to flexi-access drawdown. No new dependant’s drawdown pensions can be set up now, instead any new drawdown death benefits will be FAD.
 

Dependants scheme pension

A dependant’s scheme pension can be paid by the scheme administrator or through the purchase of an insurance company annuity. It is relatively rare for defined contribution pension schemes to provide a dependant’s scheme pension – this is a much more common under defined benefit pension schemes.

The scheme rules or the terms of the annuity contract can set out the key terms. This includes how long the pension is paid for (it does not have to be paid for the life of the dependant), the frequency of the payment (it does not have to be paid at least annually) and whether it can reduce in payment. A dependant’s scheme pension could also be deferred for example if there are continuing guaranteed instalments been paid – it does not have to start immediately following the death of the member.

A dependant’s scheme pension cannot have a guaranteed payment term or be given pension protection. It also cannot give rise to the right to a tax-free lump sum or any further benefit on death of the dependant.

If the dependant is a child, the dependant’s pension must cease at age 23 unless the child is dependant because of physical or mental impairment.

Payment of a dependant’s scheme pension is taxable as pension income in the hands of the beneficiary.
 

Transitional protection

Individuals who held lifetime allowance transitional protection will retain a higher lump sum and death benefit allowance than the standard £1,073,100. A full list of these protections and the allowance now provided can be found in our LSA and LSDBA article.

Individuals with primary protection will have their primary protection factor calculated based on the retirement benefits payable to the member on 5 April 2006. If this factor is not sufficient to remove any income tax charge on lump sum death benefits, the recipient of the lump sum can notify HMRC to allow a higher primary protection factor to be used. This will only happen if the value of the lump sum death benefits which would have been payable had the member died on 5 April 2006 is greater than the value of the retirement benefits used in the primary protection factor. Further details of primary protection and lump sum death benefits can be found in HMRC’s Pensions Tax Manual PTM176210.

 

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