Since the introduction of the 2015 pension freedoms, the rules for what happens to a pension when you die have changed.
Previously, there was a 55% ‘death tax’ on defined contribution or money purchase pension pots you wanted to pass on to loved ones if you’d already touched (known as ‘crystallising’) your pension pot.
This was abolished in 2015 and it’s now much easier for you to pass on a defined contribution pension to whoever you want, providing it remains invested in a pension or drawdown wrapper.
Before the pension freedoms, you were already able to pass down an untouched (uncrystallised) defined contribution pension pot to your loved ones free from tax providing you died before you were 75. If you were over 75 and / or had touched your pension pot, however, then you’d have to pay a death tax of 55%.
Now, if you’ve got a defined contribution pension it doesn’t matter whether you’ve touched your pension or not. Providing you die before the age of 75, your beneficiaries won’t have to pay any tax on either the lump sum they receive or any income they get from investing it in income drawdown or an annuity.
With an annuity, you’ve entered into a contract with an insurance company to swap your pension pot for a retirement income for life. You’re therefore restricted when it comes who can inherit your annuity because usually it’s a binding contract between you and the provider that is designed to cease when you die.
There are two main ways to ensure you can pass your annuity on to your spouse:
Remember, when you choose an annuity that will continue paying a nominated beneficiary after your death, you’ll usually receive a lower initial income to compensate for the fact that the insurer anticipates paying out for longer.
As with an annuity, inheriting a final salary pension is more complicated than inheriting a defined contribution pension. This is because there’s no big pot of money with your name on with a final salary pension. Instead, it’s a promise from your employer’s pension scheme to pay you an income for the rest of your life.
As a result, if you die not long after you start drawing your defined benefit pension you won’t receive as much in income from it as a longer-lived colleague, even though you both may have paid the same amount into the scheme.
Many final salary pensions allow a spouse to inherit your pension via what’s known as a widow’s or survivor’s pension. However, this only usually pays out a reduced pension and the payment ceases on their death.
To get around the difficulties of inheriting a final salary pension and take advantage of the new pension freedoms, one option is to consider a final salary pension transfer
A final salary pension transfer involves taking a cash lump sum to leave your defined benefit pension scheme and investing that cash in a defined contribution pension instead.
By doing so, you’re automatically entitled to the same pension freedoms when it comes to leaving your pension to beneficiaries as someone who’d been saving into a money purchase pension all along.
A final salary pension transfer is unlikely to be in the interests of most people. While the ability for loved ones to inherit a pension is one factor to consider when looking at whether a transfer makes sense, it’s far from the only one to examine in this complicated decision process.
As pensions are typically held outside a person’s estate, there’s usually no inheritance tax to pay on pensions. They aren’t counted when valuing a pensioner’s estate for inheritance tax purposes.
This is providing you’ve left the pension invested in a pension or drawdown arrangement at the date of your death and haven’t withdrawn the funds and are holding them in taxable vehicles, such as savings accounts.
However, you may have to pay income tax on a pension you’ve inherited, depending on the type of pension the deceased had and the age they were when they died.
A general rule of thumb for defined contribution pensions is that if the pensioner dies before the age of 75, you can usually inherit their pension tax-free.
If there’s any cash left in a loved one’s defined contribution pension or drawdown fund when they die, you can usually take this as a tax-free lump sum, providing the pensioner dies before they’re 75 and you take the cash within 2 years.
If the pensioner is over 75 when they die, then you’ll pay income tax on the inherited lump sum. This should be deducted by the provider before they make the payment to you.
If the individual was taking an adjustable pension income from an invested drawdown pot, in most cases a beneficiary can inherit this adjustable income tax-free if the pensioner dies before the age of 75. If the pensioner dies after the age of 75, then you’ll have to pay income tax on the adjustable income you receive in the usual way.
Under the new pension freedoms, if you’re named as a beneficiary on a joint annuity or an annuity with a guarantee period, there’s usually no tax to pay on the annuity you’ve inherited providing the annuitant has died before the age of 75.
This includes income tax, which was previously chargeable to the beneficiary of an inherited annuity just as it would have been levied on the original annuitant.
If the annuitant dies after the age of 75, the beneficiary of a joint annuity or an annuity with a guarantee period will be charged income tax on the annuity income in the usual way.
When a person with a final salary pension dies, the scheme will usually provide a reduced widow’s or survivor’s pension to a spouse. It may also provide a reduced income for a dependent child, although usually only until that child is 23. This offers much less flexibility than if you were to inherit a defined contribution pension.
Depending on the scheme’s rules, you may be able to nominate someone else to inherit your final salary pension, but it could face a 55% tax charge as an unauthorised payment.
The beneficiary of your final salary pension will have to pay income tax on that pension income, regardless of whether you died before or after the age of 75.
This is compared to receiving an income from a defined contribution drawdown fund, which is free from income tax if the pensioner dies before the age of 75.
Everyone has a pension lifetime allowance, which represents the maximum amount that an individual can receive from a pension scheme over their lifetime. This currently stands at £1,055,000.
Any pension benefits you receive worth in excess of this figure are subject to the lifetime allowance charge. This is levied at 55% on anything above the LTA if you take your pension as a cash lump sum.
If you’ve exceeded your lifetime allowance and convert your pension to an income, e.g. through an annuity or income drawdown, the lifetime allowance charge is 25% of that income.
The lifetime allowance charge will usually have been paid by the pensioner already if they’ve exceeded the lifetime allowance.
However, if the pensioner dies before touching their pension — known as leaving it uncrystallised — the Lifetime Allowance Charge becomes due when the beneficiary inherits the pension.
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