Pension scheme administrators normally have discretion over who receives the death benefits from a defined contribution (DC) pension.
It is part and parcel of those pensions being outside of the individual’s estate for inheritance tax purposes.
However, the administrator’s aim is to pay out benefits in the way their investor would have wanted, as expressed to them via that investor’s 'expression of wishes'. Making an expression of wishes and keeping it up to date has always been advisable, but under the current rules it is more important than ever.
Key points
- Pension freedoms transformed the death benefits landscape
- Drawdown is often considered the most flexible and tax-efficient death benefits option
- The dependant or nominee can make an expression of wishes
Before we go into exactly why this is the case, let us have a brief reminder of the rules and recent history of death benefits.
There are three possible forms of death benefits available from DC schemes:
Annuity
The beneficiary uses their share of the death benefits to purchase an annuity in a similar way to someone purchasing an annuity with their own pension benefits.
Lump sum
The funds are simply withdrawn from the pension and transferred to the beneficiary. The whole amount then forms part of the beneficiary’s estate, so if they subsequently pass away with any of the money remaining, it could affect their own inheritance tax position.
Lump sums are the only form of death benefits available to beneficiaries such as trusts and charities.
Beneficiaries’ drawdown
The beneficiary keeps the money within a pension environment where they can continue to benefit from tax-free investment growth.
The undrawn funds remain outside their estates. Income can be withdrawn in the same way as from a normal drawdown account, except that there is no minimum age and the withdrawals do not affect the beneficiary’s own lifetime or annual allowances.
Before the pension freedoms came into force on 6 April 2015, most beneficiaries only had the option to receive a lump sum death benefit. Annuities and, perhaps more significantly, drawdown, were only available to beneficiaries who could be classed as dependants. The definition of a dependant encompasses:
• Spouses and civil partners of deceased scheme members.
• Children of deceased scheme members under age 23, or older if dependent due to physical or mental impairment.
• Other individuals who were dependent on the deceased scheme member due to physical or mental impairment, or in a financially dependent relationship with the member.
Dependants in drawdown always paid income tax on the money they received. Lump sums, which as mentioned were the only option for many beneficiaries, were taxed at 55 per cent unless the deceased was below age 75 and holding uncrystallised funds.
The pension freedoms transformed the death benefits landscape. Now, lump sums and income can be paid tax free if the deceased was below 75 as long as the benefits are assigned to the beneficiaries within two years. Otherwise the benefits are subject to income tax, the 55 per cent charge has vanished altogether. Most significantly of all, any beneficiary can now potentially use their share of the death benefits to buy an annuity or put into drawdown.
