What happens to your pension when you pass away?
Although pension death benefits have received more coverage in recent years as a result of the Pensions Freedom Act of 2015, what precisely happens to your hard-earned pension fund after your death can still seem rather confusing.
There can be enormous differences in the death benefits your next of kin might be entitled to depending on what kind of pension you have, let’s have a look at the different type of pension and some examples:
Final Salary Scheme
Death benefits on final salary schemes (or any kind of ‘Defined Benefit’ scheme) can be very variable from scheme to scheme but normally follow a pattern.
• Lump Sum Death Benefit. This is usually defined as a set amount or multiple of salary. It is generally free of income tax where death occurs prior to age 75, when the benefits will be tested against the Deceased’s Lifetime Allowance where benefits are yet to be taken.
• Dependant’s Scheme Pension
This is usually defined as a percentage of the member’s benefits. The definition of dependant will vary from scheme to scheme but may include a spouse, civil partner or cohabiting partner (dependent on certain qualifying conditions). Eligible children may also be entitled to a dependant’s scheme pension. The recipient will be taxed on any income received but the benefits will not be tested against the Lifetime Allowance.
These benefits are subject to various conditions and qualifying criteria that will be dependent on the scheme terms set out by individual final salary schemes.
Example – Samantha’s Final Salary Scheme
Samantha receives a healthy final salary scheme income from many years of working for her Local Authority Council. She recently had a health scare and is worried about her spouse, whose pension income is very modest in comparison.
Some examples of final salary scheme death benefits that Samantha’s family may be entitled to are:
A lump sum death grant of three times her assumed pensionable pay if death occurs before the pension commences.
A spouse’s (pension payable to her husband equal to 2/3 of her pension at date of death. If she has already taken benefits, it is based on the full pension not taking into account having taken any cash lump sum benefits at retirement.
Defined Contribution pensions (Money Purchase plans/Personal Pensions)
Death benefits under defined contribution arrangements changed on 6 April 2015.
Benefits can generally be taken as either a lump sum or an income and are generally paid free of income tax where death occurs prior to age 75, otherwise they will become taxable. Where benefits are not in payment and death occurs prior to age 75, benefits will be tested against the Deceased’s Lifetime Allowance.
Example – Richard’s Private Personal Pension (in Drawdown)
Richard had paid into a pension through his employer throughout his working life. He built up a substantial fund through sound investment and consistent contributions, with the total pension fund standing at £600,000 by age 74. Richard takes £25,000 income each year from his pension as a ‘flexible-access drawdown’ but sadly had a tragic accident that has left him critically ill. He is very concerned about what happens to the residual fund should he pass away as he has divorced from his wife and has two children who he wants to receive the remaining pension funds in full.
Fortunately, Richard had a good financial adviser and together, they ensured that he had completed an ‘Expression of Wishes’ form, providing his pension provider with details of his children and the amount to be paid to them in the event of his death. The funds will be free from inheritance tax as most private defined contribution pension funds are not treated as part of your Estate (though there are some notable exceptions).
With that taken care of, the remaining concern is the income tax treatment of the fund that is passed on to Richard’s children, which is as follows:
If death occurs before Richard’s 75th birthday
Richard’s children receive their entitlement from the pension provider as a tax-free private pension fund, from which they can draw as much or as little as they would like.
They can leave it invested for their own retirements or begin using the fund.
They can nominate their own children to receive the funds in the event of their deaths and pass money through generations of the family. The fund will remain free of inheritance tax provided it stays within the pension and the fund will remain income tax free for their next of kin if they were to pass away before their 75th birthdays.
The fund will not count against their own Lifetime Allowances and so they can continue to save into their own pensions.
If death occurs after Richard’s 75th birthday
The rules are broadly similar however, any income drawn from the fund by Richard’s children will be subject to their marginal rate of income tax. This means that very careful consideration must be given before any drawings are made.
As you will have gathered, pensions, if used in the right way, can be an extremely effective means of safeguarding your family’s income should anything happen to you, as well as giving you an efficient way of passing wealth through the generations.
Many people forget about their pensions or let them sit in the background. They do not take the appropriate steps to ensure pension Death Benefits will be distributed in line with their wishes. It can be simple to resolve this and it is something everyone who has a pension should consider.
Need help with your pension planning? Please get in touch.