Pension Death Benefits & Succession Planning

Any portion of your estate over the value of £325,000 will be subject to inheritance tax (IHT) at the rate of 40% when you die. The rules surrounding your non-pension assets are very complex and there can be additional reliefs/exemptions available. However, in the case of a pension, the asset is usually held in a discretionary trust. This means that the pension is not a part of your estate and is therefore not subject to IHT.

Thanks to changes in pension regulations over the last few years, UK pension holders have been presented with new opportunities for choice and flexibility – not only in regard to retirement income, but also as a way to pass on wealth to their loved ones. When considering succession planning, it’s vital to look at your pension.

Defined benefit pension

What is a defined benefit pension?

A defined benefit (DB) pension is provided by an employer, who pays into the scheme on behalf of its employees. In most cases employees will pay into the pension too. The funds are invested by the trustees of the pension scheme to build a pension pot for members.

Only available as a workplace pension, the defined benefit scheme provides a guaranteed income for life, based on the number of years you’ve worked for a company and your final – or average – salary. An accrual rate of 1/60 or 1/80 is typically used to calculate the annual income that would be paid to you by a DB pension.

The formula for working out your pension income per year is: (salary x accrual rate) x years worked.

Read more: Guide to pension consolidation

What happens to a defined benefit pension when you die?

Your DB pension scheme might also provide for a dependant, typically this would be a spouse, civil partner, child under 18, child under 23 and in full-time education, or child of any age who is dependent on the member because of physical or mental impairment. A dependant’s pension is a percentage of what you were receiving – or, if you die before retirement, would have been receiving. This money is subject to income tax.

If you die before receiving pension payments from the scheme, your beneficiaries could receive a tax-free lump sum (a multiple of your final or average salary) if they claim the payment within two years of your passing. If more than two years pass before the pension is claimed, the money will be subject to income tax.

There’s usually a requirement to start drawing a DB pension by the age of 75.

How does a defined benefit guarantee work?

Your DB pension might have a guarantee period, which could be five or ten years.

If you die before the end of the guarantee period and are already receiving your pension payments, your beneficiaries will receive a lump sum. This will be the amount that would have been due to you between the time of your death and the end of the guarantee period.

If you die before the age of 75, there’s no tax to pay on this lump sum. If you die after your 75th birthday, your beneficiaries must pay income tax on the lump sum.

Defined contribution pension

What is a defined contribution pension?

A defined contribution (DC) pension, also known as a money purchase scheme, is a flexible pension scheme that allows you to vary how much money you pay in and when you pay it in. The government also contributes in the form of tax relief. In the case of a workplace DC scheme, the employer usually contributes as well.

The value of your pension pot is determined by the amount of money paid in and the performance of investments. The value of investments might go up or down.

From the age of 55, you can access your pension, even if you’re still working and/or paying in. You have the option to draw up to 25% of your pension pot tax-free. When the money moves from your pension into your bank account, it becomes part of your estate and subject to inheritance tax.

After taking your tax-free lump sum (if you choose to do so), you can move your money into income drawdown or buy an annuity. Or a combination of the two.

Lifetime and fixed-term annuities

A lifetime annuity, bought from an insurance company, pays you a guaranteed income for the rest of your life. Your age and health will affect the amount you receive; the older you are, and the poorer your health, the higher your annuity income will be. This is because your life expectancy is less than that of a younger and / or healthier person.

A fixed-term annuity will pay you an income for a fixed period of time – up to 40 years, but typically five or ten years. The money you pay for your annuity is invested, and at the end of the term you receive a lump sum. This will be the amount you paid for the annuity, plus investment growth, minus charges and the amount you’ve already received in annual payments. This sum can be used to buy another annuity or can be moved into a pension drawdown scheme.

Pension drawdown

With pension drawdown, also known as flexible retirement income, your money remains invested and you can draw a taxable income from your pension pot as and when you choose. However, unlike a lifetime annuity, the income is not guaranteed for the rest of your life. How long the money lasts for will depend on how much is taken as an income and where the money is invested.

You can continue to pay into your pension even after you start to draw from it. However, to prevent “pension income recycling” (double tax relief) the amount you can pay into your pension each year and receive tax relief decreases to £10,000. This is called the money purchase annual allowance (MPAA).

What happens to a defined contribution pension when you die?

How your DC pension is passed on to your beneficiaries depends on:

Your age when you die
Whether you’ve received any money from your pension pot when you die
Whether your pension is in the form of an annuity or a flexible retirement income

What happens to an untouched DC pension when you die?

If you die before the age of 75, and no money has been taken from your pension pot, your beneficiaries have two years to claim the money tax free.

If the untouched pension is claimed after more than two years, or if you die after your 75th birthday without having drawn anything from your pension, the money is subject to income tax.

Your beneficiaries can take the money as a lump sum or use it to buy an annuity.

Depending on the scheme provider, they might be able to use the money to set up a flexible retirement income. If this option isn’t available, a financial adviser will offer guidance on moving pension funds to an alternative scheme.

What happens to an annuity when you die?

If you have no death benefits in place, annuity payments stop when you die.

However, ‘value protection’ and ‘guaranteed minimum payment period’ are both ways to leave money to your spouse or children when you die.

Value protection guarantees a percentage of the amount you paid for your annuity. The protected portion could be anything up to 100%.Alternatively, you can set a guaranteed minimum payment period, which can be anything up to 30 years. If you die within the guarantee period, your annuity will be paid for the remainder of that period to your named beneficiary.

The longer your guaranteed minimum payment period, the smaller your annual payments will be.

What happens to a flexible retirement income when you die?

If you’re receiving a flexible retirement income (pension drawdown) when you die, your beneficiaries will inherit the remainder of your pension pot. They can take the money as a lump sum or use it to buy an annuity. Alternatively, an adult beneficiary can continue to pay into, and draw down from, an inherited pension, even if they’re under 55.As an inherited pension fund doesn’t count towards a beneficiary’s own lifetime allowance, there is an opportunity to accumulate more wealth within a pension scheme for future generations.

If you die before you’re 75, there’ll be no tax due. If you’re over 75 when you die, income tax is due on all monies.

How can a financial adviser help you with pension succession planning?

The world of personal pensions has become complex. Deciding on the type of pension you take, how much you pay in, how you choose your investments, how much money you’ll need to live on in retirement, and whether you should transfer pension funds from one provider to another are all questions that can be talked through with an expert.

In some instances, there’s a legal requirement to take advice from an FCA-certified professional before taking action.

Read more: Guide to children's pensions

The value of investments and any income from them can go down as well as up and you might not get back the original amount invested. The past is not a guide to the future.

The value of tax benefits depends on your individual circumstances. Tax laws can change.

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Guide to pension death benefits and succession planning

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