Inheriting a Pension – changes to death benefits

It should be noted that the commentary below relates exclusively to pension funds (also known as defined contribution pension funds). Defined benefit, or final salary, pensions have a very different treatment on death that will be defined by the specific rules of that pension scheme.

The current rules are as follows:

If death occurs before age 75, the pension fund can pass entirely tax-free* to any beneficiary as long as it has been assigned within two years. This can take the form of:

1. a tax-free lump sum paid to the beneficiary's bank account.
2. a beneficiary pension fund that the beneficiary can draw from tax-free at any time (whilst keeping the funds outside their own estate for IHT purposes, and growing tax-free).
3. a beneficiary annuity that will pay a tax-free income for the life of the beneficiary.

*Note - a Lifetime Allowance tax charge may apply on death before age 75 if the individual breached their Lifetime Allowance. However, following the Chancellor’s announcement that the Lifetime Allowance will effectively be abolished from 6 April 2024, this is now somewhat a moot point.

If death occurs after age 75, the pension fund can still pass tax-free to any beneficiary. However, when the beneficiary accesses the fund, they pay tax based on their Income Tax position. As such the options in this scenario are:

1. a lump sum can be paid to the beneficiary but it will be taxed as income and will therefore typically suffer a significant Income Tax deduction.
2. a beneficiary pension fund can be created. When the beneficiary draws on the fund, they then pay income at their marginal rate of Income Tax.
   This has been the most popular route in recent years as it enables beneficiaries to manage their personal tax positions over time whilst keeping the funds outside of their estate for IHT purposes, and still growing tax-free.
   Furthermore, we have often encouraged clients to think about which beneficiaries within the family could access the funds most tax-efficiently given their own tax positions, and have then constructed death benefit nominations around this - often with grandchildren taking a greater share of the funds than they may otherwise have done.
3. a beneficiary annuity can be secured but this income will be taxable.

In addition, if a beneficiary dies with funds remaining within their beneficiary pension, that beneficiary pension can continue to pass to the next generation upon their death, in line with their wishes. The same rules as above will apply, based upon the beneficiaries age at the date of death. Effectively, this means pensions can be used as a tool to cascade wealth across multiple generations, free of IHT.

This attractive tax treatment on death, paired with the fact that pension assets grow without the deduction of any Income Tax or Capital Gains Tax, has led to those who don't need their pension funds in retirement viewing their pension as the last asset they should touch.

A common strategy in recent years has been to withhold drawing from pension funds, or at least limit withdrawals to a tax-efficient level, and draw on other, less tax-efficient assets that will be subject to IHT instead.

However, you do not have to go too far back, to find a very different story on the tax efficiency of pensions on death. Before 6 April 2015 a "special lump sum death benefit charge" existed at a rate of 55%. This applied when someone died after age 75 and did not have a financial dependant to pass the fund to (broadly a spouse/partner or a child under the age of 23).

As such, whilst the current rules set out above were seen as a significant positive when introduced in 2015, there has always been a question in our minds as to how long these rules will remain in their current form.

Changes being introduced for the 2024/25 tax year

With the abolition of the Lifetime Allowance date announced for 6 April 2024, a review of various elements of pension legislation is required. An example is changes to the tax-free lump sums.

The Government have also reviewed pension death benefits and proposed some subtle but significant changes from 6 April 2024 onwards.

The proposed changes are still in draft form at present, and there is a significant amount of detail still to be confirmed. However, our interpretation of the changes is as follows:

• The death benefit options and the tax treatment of those where death occurs after age 75 do not seem to have any significant changes.
• The proposals suggest that all pension income will become taxable from 6 April 2024 and therefore we believe that the only way to access funds tax-free on death before age 75 will be to take a death benefit lump sum (option 1 above).
  This will be a less tax-efficient option than the existing one, using a tax-free beneficiary pension, and will require beneficiaries to more carefully plan their personal tax and IHT positions after receiving such lump sums.
• We expect that this change will bring about more trust planning where death occurs before age 75 i.e. putting the tax-free lump sum into trust, rather than passing directly to individual beneficiaries. However, trusts naturally bring complexities of their own.
• There will also be new rules dictating the level of tax-free lump sums that can be paid in life and on death and this will add further complexities to pension death benefit planning.
• Lastly and crucially, there are a large number of people who now hold tax-free beneficiary pensions following the death of family/friends prior to age 75 (option 2. above). The wording in the proposed legislation suggests that those funds may become taxable after 6 April 2024 and, whilst we hope this will not pass through to legislation - we would hope that some form of transitional protection will be afforded to those individuals - it is certainly an area of concern and focus.

Whilst the proposed changes are still in draft, we feel that all individuals with pension funds should be considering the following prior to 6 April 2024:

• Their pension death benefit nominations, and considering the use of a trust to receive pension death benefits.
• If you hold a tax-free beneficiary pension, keep a very close eye on upcoming legislative changes and take advice accordingly.
• Ultimately, given all of the changes to Lifetime Allowance legislation, contribution limits, lump sum rules and death benefit options, a review of your wider pension planning position is advisable.

If you would like to speak with one of our pensions specialists about changes to pensions death benefits or general pension planning, please get in touch.

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