Lee Halpin: Pension death benefits need not be taxing

The 55% tax on DC pensions savings on death before age 75 has been abolished, but care must be taken to ensure inaction doesn’t lead to unintended consequences, writes Lee Halpin. Here, he discusses the importance of factoring pension saving into estate planning

“In this world nothing can be said to be certain, except death and taxes” Benjamin Franklin famously said after signing the constitution of the United States. But in the context of leaving your pension savings to your loved ones, death and taxes needed be mutually inclusive events.

But while four years have been and gone since it was announced that the 55% tax on defined contribution (DC) pension savings on death before age 75 was to be abolished, care needs to be taken to ensure inaction doesn’t lead to unintended consequences.

Generally, where the pension scheme member can nominate who will receive any death benefit, and the pension scheme provider is bound to comply with that nomination, the payment falls within the member’s estate.

For this reason, and in order to avoid the associated potential inheritance tax, most pension schemes are structured to allow members to nominate specified beneficiaries but these are generally not binding nominations, rather the pension scheme trustees have discretion as to how death benefits are applied.

However, in exercising their discretion as to who is to receive death benefits under a pension, the trustees should take into account all relevant considerations (and no irrelevant considerations), act in accordance with the relevant provisions of the scheme documentation and not reach a decision which no reasonable body of trustees could have reached or which is unlawfully discriminatory.

So expressions of wishes, that record what the member would like to happen with the death benefits, are a significant means that should be used to inform the trustees decision making process. It is also good practice to keep such expressions of wishes under periodic review.

Importantly, by also completing an expression of wishes it reduces the likelihood that the death benefits will be paid to your estate and thus avoiding inheritance tax issues.

A key aspect of the pension death benefit reforms was the introduction of the ability for pension wealth to be cascaded through the generations, possibly in perpetuity. But crucially, the ability to pass on your pension intact (rather than paying it out as a lump sum) is limited to dependants (e.g. a surviving spouse) and nominated persons.

So non-dependants (e.g. adult children) would be precluded from inheriting your pension, or an element of it, intact if they have not been expressly nominated by you. While they could still receive death benefits under your pension this would be limited to the form of a lump sum benefit.

As a consequence, the benefits would now be out with the pension tax shelter – forgoing the generous exemption to income and capital gain taxes afforded to pension scheme assets.

Even in situations where you will not be survived by dependants or beneficiaries, inaction can have significant adverse consequences.

For example, while a tax free lump sum death benefit can be paid from a drawdown fund to a charity, a qualifying condition of such a tax-free payment is that the charity was nominated by the pension scheme member.

While a lump sum death benefit may be paid to a non-nominated charity a hefty tax charge at a flat rate of 45% would apply.

With the lifetime allowance for pensions savings currently set at £1,030,000 (to be increased to £1,055,000 for 2019/20 in line with CPI), the absence of advanced planning can lead to unnecessary tax charges.

Pension death benefits paid from uncrystallised funds will be tested against your lifetime allowance, where death occurs before age 75. Any fund in excess of the lifetime allowance will be subject to a tax charge – at a rate of 25% if paid as a pension income or at a rate of 55% if paid as a lump sum.

But a lifetime allowance test might not be restricted to just your lifetime pension savings. If your employer’s death in service cover (typically providing a lump sum based on a multiple of salary) is structured as a registered scheme any related benefit paid will also count towards your lifetime allowance.

Excepted life policies circumvent this problem, so again being proactive can lead to more tax efficient outcomes.

Clearly, spending a little time now thinking about the pension savings you may leave behind can be time well spent.

Lee Halpin is technical director at @sipp