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.
Which Pensions Can Be Inherited?
As mentioned, changes to the pension legislation mostly affected the inheritance of defined contribution pension pots, specifically those in income drawdown.
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.
Who Can Inherit My 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:
- A joint life annuity
Most annuities are single life annuities and cover just the life of you (the annuitant) only, but a joint life annuity will continue paying out a proportion of your annuity to a designated dependent after your death
- An annuity with a guarantee period
These annuities will continue paying out for a set number of years to your chosen beneficiary after your death, depending on the length of guarantee period you choose (e.g. if you have a 10 year guarantee period and die after only drawing on your annuity for 1 year, the annuity will pay your beneficiary for 9 more years).
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.
Can You Inherit a Final Salary Pension?
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.
Transferring a Final Salary Pension…
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.