Death Benefits
If I were to die before taking benefits, how would the death benefit payable be taxed?
This depends on whether you die before or after age 75 and (if you were to die before age 75) whether the death benefits will be paid to your nominated beneficiaries more or less than 2 years after the date of your death but the tax treatment can be summarised as follows:
Death before age 75 and payment made within 2 years of death
In the event of your death before age 75 and regardless of whether the fund will be used to pay your nominated beneficiaries a lump sum, an annuity or a drawdown pension then whilst if this is paid within 2 years of death the value of the fund will need to be tested against your available lifetime allowance (LTA), as long as the value of the fund is within your available LTA there will be no LTA charge and the whole of any lump sum and/or annuity or drawdown income payments will also be income tax free.
If, however, your available LTA is exceeded then whilst any excess paid as a lump sum will be subject to a 55% LTA charge and any excess that is used to pay a beneficiary an annuity or drawdown pension will be subject to a 25% LTA charge, any lump sum and/or annuity or drawdown income payments will still be income tax free.
Death before age 75 and payment made more than 2 years after death
If following your death before age 75 any lump sum or annuity or drawdown pension is paid outside this 2 year window, there will be no test against your available LTA but the whole of any lump sum and/or annuity or drawdown income payments will be subject to income tax in the hands of the beneficiary at their own marginal rate(s).
Death on or after age 75
If you die after you have attained age 75 (and regardless of whether a lump sum, annuity or drawdown pension is paid more or less than 2 years after your death) there will be no test against your available LTA but the whole of any lump sum and/or annuity or drawdown income payments will be subject to income tax in the hands of the beneficiary at their own marginal rate(s).
If someone dies in flexi-access drawdown, what death benefits can be paid and how would they be taxed?
If a member in flexi-access drawdown dies, the remaining funds on death can be paid as a:
- Dependant's pension (payable as a dependant's scheme pension, dependant's lifetime annuity or a dependant's flexi-access drawdown); and/or
- Nominee's lifetime annuity; and/or
- Nominee's flexi-access drawdown pension; and/or
- Lump sum to one or more individuals (or into trust), and/or
- Charity lump sum death benefit (but only if there are no surviving dependants of the member and the member has nominated the charity)
On the death of an individual in receipt of a dependant's or nominee's flexi-access drawdown pension any remaining funds can then be paid as another dependant's flexi-access drawdown pension, a successor's flexi-access drawdown pension or as a lump sum.
Who is a nominee?
This is an individual who has been nominated by a member (or failing that, the scheme administrator) who is not a dependant of the deceased member, to receive a flexi-access drawdown pension.
This change therefore means that, unlike the situation prior to 6 April 2015 where the only option for a non-dependant of the deceased member was to receive a lump sum, any individual can inherit unused drawdown funds on the death of the member and continue in drawdown in their own name.
Who is a successor?
Where an individual dies whilst in receipt of a dependant's or nominee's flexi-access drawdown pension and leaves a residual fund, an alternative to paying this residual fund as a lump sum or an annuity to a beneficiary would be to instead pay it as flexi-access drawdown pension to another nominated individual, defined as 'a successor'. The drawdown pension that has been inherited by the successor would then become a successor's flexi-access drawdown pension fund. On the death of a successor, they can then nominate another individual to receive another successor's flexi-access drawdown pension.
These changes therefore allow accumulated pension wealth to potentially cascade down the generations, whilst continuing to benefit from the tax advantages that the pension wrapper provides.
How is a drawdown lump sum death benefit taxed?
Death before age 75
Drawdown funds paid as a lump sum within two years of death to a dependant or nominee will be tax-free. There is no test against the deceased's lifetime allowance.
If the drawdown funds are instead paid as a lump after two years, the lump sum will be taxed at the recipient's marginal rate. There is no test against the deceased's lifetime allowance.
Death after age 75
Any drawdown funds paid as a lump sum to a dependant or nominee will be taxed at the recipient’s marginal rate (reduced from 45% in 2015/16). This will apply regardless of whether the lump sum is paid within 2 years of death. There is no test against the deceased's lifetime allowance.
How will flexi-access income withdrawals be taxed, following the death of the member, in the hands of a dependant or nominee?
Death before age 75
If the member dies in drawdown before age 75, the payment of any income withdrawals to a dependant or nominee will be tax free. There is no two year window for having to designate the funds to drawdown for a beneficiary in order for the income received to be tax free and there is no test against the deceased's lifetime allowance.
Death after age 75
If the member dies in drawdown after age 75, the payment of any income withdrawals to a dependant or nominee will be subject to income tax in the recipient's hands at their marginal rate(s).
This will apply regardless of whether the designation is made within 2 years of death and there is no test against the deceased's lifetime allowance.
How will flexi-access income withdrawals be taxed, following the death of a dependant or nominee, in the hands of a successor?
Each time a pension fund is inherited, the tax rate will be reset by the age at death of the last drawdown account holder.
For example Jim, a widower, dies age 83 and nominates his son John to receive his drawdown fund. As Jim died after age 75, John is taxable at his marginal rate on any income withdrawals. However, if John dies before age 75 and leaves the remaining fund to his daughter Jane, Jane can take withdrawals from her successor's drawdown pension tax free.
Drawdown and IHT
It is our understanding of HMRC practice that (and unless a member in ill health transfers from one pension scheme to another and they fail to survive the transfer by two years) there should be no IHT charge on pension death benefits, irrespective of whether they are in respect of uncrystallised or crystallised rights or whether the member dies before or after they have attained age 75. This, however, is of course subject to meeting the other requirements for benefits to be paid IHT free such as the need for the death benefits to be written in trust and paid at the discretion of the trustees.
With effect from 6 April 2011, and again assuming that the death benefits are written in trust and the trustees can exercise discretion when deciding who should benefit, there should be no potential IHT liability even if someone in ill-health dies within 2 years of entering drawdown (and who therefore failed to exercise their right to purchase an annuity) or someone in income drawdown dies within 2 years of deliberately reducing their withdrawals in order to enhance the value of the fund on death that could subsequently be used to pay death benefits to their nominated beneficiaries.
Flexi-access drawdown - Pros and Cons
Advantages
- You will be able to take the maximum tax-free cash lump sum immediately to spend or invest without having to convert the rest of the fund to an annuity
- If you take the tax-free cash only (and assuming that you have not already accessed pension benefits 'flexibly' from another pension arrangement) you will not trigger the £4,000 money purchase annual allowance until such time that you chose to take any income withdrawals from the balance of your fund that has been designated to flexi-access drawdown
- Variable Income - If you do require an income you may choose to take any level of income that you require, without limit, whether it be a regular income or on an ad-hoc basis
- After taking into account any other sources of income which may be available to you, you will be able to plan in advance the level of income that you wish to take each year from your flexi-access drawdown pension
- You can structure your income to mitigate your liability to Income Tax. For example, by reducing drawdown income in some tax years, you may be able to avoid a higher rate income tax liability
- The pension fund (less any income withdrawn and associated charges) will continue to be invested in a tax efficient environment until you decide to purchase an annuity or continue drawdown past age 75
- Depending upon investment returns, which can fall as well as rise and are not guaranteed, this may provide the opportunity to achieve sufficient growth to improve the ultimate benefits when (and if) you decide the time is right to purchase an annuity
- You may be able to use income drawdown as part of your Inheritance Tax planning by taking varying levels of income, and using all or part of that income to make gifts that take advantage of the various IHT exemptions that are available such as the £3,000 annual exemption, the normal expenditure out of income exemption and gifts to spouses or charities
- Flexible options on death. For example, a surviving beneficiary (such as your spouse) could continue drawdown in their own name, buy an annuity or take the residual fund as a lump sum. If you die before age 75, any lump sum or pension benefits paid as an income to a beneficiary should be tax- free in the hands of the recipient
- As you get older there is the prospect of annuity rates rising and therefore providing a higher income. This is because it is cheaper for insurance companies to purchase an annuity to provide a given level of income for someone aged, say 70, than someone aged 60
Disadvantages
- A careful investment portfolio needs to be drawn up which will involve investment risk and a reliance upon investment management
- A minimum level of growth must be achieved by the remaining pension fund in drawdown in order to maintain its value after the income payments have been taken (assuming an income is taken of course). If this 'critical yield' is not achieved the fund may be unable to purchase an annuity equivalent to that which could have been purchased at outset if income withdrawals had not been selected
- Any investment returns may be less than those shown in the illustrations
- Should a high level of income be taken, then unless there is exceptional growth the level of withdrawals may not be sustainable
- Deferment of the purchase of an annuity may result in less favourable annuity rates if and when a purchase is eventually made
- In addition, the investment fund may be depleted, either through investment performance or withdrawals, to the extent that even if current annuity rates are maintained, the annuity which can be purchased in the future will drop
- As soon as you take any income withdrawals from your flexi-access drawdown pension (and assuming you haven't already accessed benefits 'flexibly' from any other money purchase pension arrangements before this one), this will trigger the £4,000 money purchase annual allowance
- All income withdrawals are liable to income tax at your highest marginal rate(s), although it is possible under drawdown to defer any income payments which may be surplus to requirements
- Increased flexibility brings increased costs and the need to review arrangements on an ongoing basis
- Lump sum death benefits paid from drawdown funds, on death after age 75, are taxed at the recipient's marginal rate(s) (reduced from 45% in 2015/16)
- You may feel that the prospect of future higher income does not compensate you for being able to enjoy a guaranteed and secure level of income today and for the rest of your life
- Annuity providers make a profit from the fact that some individuals die sooner than is expected and use some of this 'mortality profit' to enhance current annuity rates. By delaying the purchase of your annuity, the benefit of this potential profit, which can be significant, may be lost
Uncrystallised Funds Pension Lump Sum
From 6 April 2015, and subject to the pension provider allowing it, members of pension age will be able to take what they want from their money purchase pension pot, whenever they want it.
As an alternative to entering flexi-access drawdown, this can be achieved by taking an uncrystallised funds pension lump sum (UFPLS).
Under the UFPLS option, an individual can take a single or series of lump sums from their uncrystallised funds, without having to designate them to drawdown first.
25% of the amount paid will normally be tax-free, with the remainder taxable as pension income.
The conditions that need to be met are as follows:
- It can only be paid from uncrystallised rights held under a money purchase arrangement
- The individual must be at least 55 or (if younger) be able to meet the ill-health early retirement conditions or have a protected pension age.
- If under 75, the member must have enough lifetime allowance available to cover the full amount of the UFPLS
- If over 75, the member only needs to have some lifetime allowance left when they want to take the UFPLS (but if the UFPLS is more than their available lifetime allowance, the tax-free part of the payment will be limited)
Once a UFPLS has been paid, the member will then be subject to the £4,000 money purchase annual allowance.
However, an individual cannot be paid a UFPLS if:
- They have registered tax free cash rights under either primary protection or enhanced protection; or
- They have a lifetime allowance enhancement factor (e.g. because they have received a pension credit on divorce from a pension already in payment) and the available portion of their lump sum allowance is less than 25% of the proposed uncrystallised funds pension lump sum.
Third Way Pensions
Third Way Pensions fit in between a conventional annuity and an Income Drawdown plan as they offer the chance to still participate in stock market growth but with guarantees attached to either income, capital or both. Whilst each specific product differs in its features, the 'Third Way' pension is usually structured in one of two ways:
Annuity - This option is commonly structured as a fixed term, value protected annuity plan, typically running for 5 years at a time, with the option to include guarantees to protect maturity values or the level of income. Unlike a traditional lifetime annuity, these products tend to offer the ability to alter income levels between certain limits and importantly, also allow the facility to provide a lump sum on death.
Income Drawdown - The second type of Third Way plan is structured as an Income Drawdown plan but with the option to apply a guarantee to the initial investment so that your fund value will never fall below what you originally paid into the plan. Some plans also allow all or a portion of any growth in the plan's value to be locked in and a new minimum guaranteed level is then set. The option to select a guaranteed level of income is also commonly available.
Under both of the above options, you can choose to immediately take a tax-free cash lump sum and then, instead of buying an annuity, leave the remainder of the fund invested in a tax-efficient environment. If the income is not guaranteed it may vary between set limits and will be reviewed at some point between 1 year and 5 years depending on the product chosen.
Advantages
- You are able to take all of your tax-free cash lump sum entitlement at outset
- Unless a guaranteed income is selected, you do not have to receive a set income but are able to vary it to suit your personal circumstances, up to a maximum limit, to supplement other sources of income
- You are able to mitigate your liability to personal income tax in certain years
- You have the potential to benefit from good investment performance in a tax-efficient environment and to exercise control over your own investment portfolio
- You are able to add a safeguard in the form of a guarantee to limit any drop in your fund value and some products allow gains to be locked in
Disadvantages
- Taking withdrawals may erode the capital value of the fund, especially if investment returns are poor and a high level of income is being taken. This could result in a lower income when an annuity is eventually purchased and could also affect the long term financial security of your spouse/partner
- Annuity rates may be at a worse level when annuity purchase takes place. Although annuity rates generally increase with age, they have fallen dramatically during the past 15 years. This trend may continue
- A careful investment portfolio needs to be constructed which will involve some investment risk. If capital guarantees are not included, then this means the fund value could fall which could affect your future income levels
- Increased flexibility and the addition of guarantees bring increased costs and the need to review arrangements on a regular basis
- There is no guarantee that your future income will be as high as that offered by an annuity purchased today
- You may feel the prospect of the future higher income does not compensate for the known income available from an annuity now and for the rest of your life.
Past performance is not a guide to future performance. Changes in the exchange rate will affect the sterling value of your investment. The value of investments (including property) and the income derived from them may go down as well as up.