Pension - Death Benefits and Intergenerational Pension Planning
The exact rules for pension death benefits will vary depending on the type of pension you have and your age on death.
Pensions from ‘defined benefit’ pots can usually only be paid to a dependant of a deceased owner, such as a husband, wife, civil partner or child under 23. They can sometimes be paid to someone else if the pension scheme’s rules allow it – but the fund will be taxed at up to 55% as an ‘unauthorised payment’.
One of the great tax advantages of personal pensions or SIPPs is that, being ‘defined contribution’ pots, they allow you to pass on your pension fund to nominated beneficiaries (not necessarily a dependant) of your choice on your death. Unlike defined benefit schemes or retirement annuity incomes, there is also no limit as to the number of times a SIPP pension pot can be passed down to the next generation.
How do I nominate beneficiaries for my SIPP fund and are the nominations binding?
A nomination or Expression of Wish form normally forms part of the original SIPP application. Pension providers typically ask you to nominate one or more beneficiary/ies when you take out a plan. You can nominate whoever you like to receive your SIPP on your death; this could be your spouse, children or grandchildren, or you can nominate someone unrelated to you if you wish. You can also leave some, or all, of your SIPP to charity. You don’t need to leave your pension to just one person; you can split it in whatever proportion you like, so each of your beneficiaries receives a share of your SIPP.
Your SIPP provider or the plan administrator will have discretion over how your pension is passed on so it is important that they understand your wishes. If your wishes are not clear, a claim may not be processed in the way you intended. It is important to list all beneficiaries and any additional wishes you want the pension scheme trustees to take into account when deciding on the distribution of your benefits. It is also important that your nominations are regularly reviewed and kept updated to ensure that your wishes for your fund are carried out when you pass away and that claims are not delayed.
Although the pension scheme trustees have discretion on how your benefits will be paid on death, it is rare that nominations aren’t followed. Usually, this only happens if there has been a change of circumstance (for instance, a divorce) and your wishes haven’t been updated.
How will the SIPP death benefits be paid?
Your pension beneficiaries will usually be able to choose to take the full pension pot as a lump sum or leave it invested in a SIPP of their own, taking a flexible income from the fund as and when required should they so wish.
Funds left invested will continue to benefit from potential investment growth and the tax advantages that pension wrappers have - investment income and gains received by pension scheme fund managers are free of tax.
If a beneficiary requires a secure level of income in the future, they will always have the option to use the fund at any time to purchase a lifetime annuity income from an insurance company. This will provide them with a guaranteed, regular level of income for life.
What tax will need to be paid by the beneficiaries?
Death benefits where the SIPP holder dies before age 75 are typically tax free (if ‘designated’ to the beneficiaries within two years of death). However, it should be noted that the government is currently reviewing this and it is possible that they may decide to impose a tax on these benefits in the future.
Should you have passed age 75 on the date of death, the death benefits when withdrawn (lump sum or income) will be taxed at your beneficiary’s marginal rate of income tax. Any withdrawals will be added to your beneficiary’s other non-savings income (such as State Pension, private pension, any salary or rental income) and taxed at the appropriate rate, after the deduction of any Personal Allowance. Tax on withdrawals will be collected by the pension provider under PAYE.
For example, should your beneficiary be a basic rate tax payer at the time of your death, the beneficiary will pay basic rate tax at 20% (provided that they don’t take income that takes them above the threshold for higher rate tax). Should your beneficiary be a non tax-payer with no other income (potentially a grandchild), they could take out up to the Personal Allowance of currently £12,570 each year without paying any tax. Any amount over this would be taxed at the basic rate. They could however of course take no income should they so wish.
It should be noted that if your beneficiary is not an individual, for example if a trust has been nominated, then benefits will be paid as a lump sum and taxed at 45%. Payments to a charity on death over 75 will not be taxed provided you have nominated the charity and there were no surviving dependants. If this is not the case, the death benefits to the charity would be taxed at 45%.
Inherited pension funds will not typically be included in a beneficiary’s estate for inheritance tax purposes.
What happens to the SIPP fund when the beneficiary dies?
If your beneficiary has not withdrawn the entire pension fund before their own death, then the funds can be passed on again in the same way. Your beneficiary can nominate successors who they want the funds to go to following their death.
Any successors will then have the option of taking the fund as a lump sum or using it to provide an income. The tax treatment of the death benefits will depend on the age of the beneficiary who was holding the pension at their death, not on how old you were at your death (the taxation depends on the age at death of the last owner of the fund). It is possible therefore for withdrawals from an inherited fund to be taxed differently as it passes to new beneficiaries on successive deaths.
It is possible to have unlimited successors, so your pension fund could be passed on for generations if it is not all taken out.
As you can see, pension death benefits can be very attractive from a financial planning perspective and it is important to consider this aspect when making decisions on your retirement planning and also estate planning. The first (and most important) step is to ensure you make a pension nomination in the correct way to ensure your beneficiaries can ultimately benefit from your hard-earned pension funds in the most tax efficient way for them.
All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and Her Majesty’s Revenue and Customs (HMRC) practice. Levels and basis of tax relief are subject to change.