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Paying pension death benefits

The trustees or scheme administrators of a money purchase pension will typically have discretion over the payment of death benefits - unless a binding nomination has been made.

The scheme rules will determine the range of possible beneficiaries. This will typically allow payments to family and friends, trusts which the settlor created during their lifetime, trusts created in the scheme member's will and charities.

Individuals potentially have the choice of a lump sum or a pension (via income drawdown, a lifetime annuity or a scheme pension) whereas nominated charities and trusts can only receive lump sums.

However, the options for individuals may be limited by what the scheme will allow - for example, not all schemes can facilitate income drawdown and very few DC schemes would allow a dependant's scheme pension - but a lack of a nomination can sometimes restrict the options where death benefits are to be paid to a non-dependant.  

The importance of a nomination

A nomination form (or a letter of wishes) allows the pension scheme member to tell the trustees/administrators who they would like to benefit on death. The nomination helps to guide scheme administrators/trustees with their decision making.

They will complete their own investigations following the member's death and use their discretion. But often they will follow the instructions in the nomination unless there's good reason not to.

Dependants and nominated individuals will have the choice of a lump sum or a pension, whereas nominated charities and trusts can only receive lump sums.

For non-dependants, nominations can be crucial - if they haven't been nominated, but the trustees or scheme administrator decides that they should benefit, then sometimes their only option is a lump sum. This is because, if the deceased:

• had nominated another individual (or a trust or charity) or
• has a dependant,

then the trustees or provider can’t allow anyone else to use the funds for pension purposes.

However, the existence of a dependant is only relevant on the death of the original member. It’s not relevant when paying death benefits from beneficiary's drawdown funds.

Lump sum or pension

If a non-dependant beneficiary has not been nominated, the only option will be a lump sum if there is a surviving dependant or someone else who has been nominated.

Dependants or beneficiaries who have been nominated will have the choice of whether take a lump sum or a pension, typically via beneficiary's drawdown (if offered by the scheme) or an annuity.

If a lump sum is paid out to a beneficiary, it will be in the beneficiary's estate. If it’s then invested, the funds may be subject to income tax and capital gains tax on future investment returns.

Beneficiary's drawdown allows pension wealth to remain within the pension wrapper. There's no tax on income and gains from investments within the pension fund and the value of the pension funds is outside the beneficiary's estate for IHT. Income can be taken as and when the beneficiary needs it.

Beneficiaries don't need to be age 55 to access the death benefits.  

Taxation of death benefits pre-75

The removal of the lifetime allowance has resulted in a change to the taxation of death benefits for those with large pension pots. Lump sums will remain tax-free up to the available lump sum and death benefit allowance (LSDBA) - the standard LSDBA is £1,073,100, but those who have transitional protection will have a higher allowance. Any excess above the LSDBA will be subject to income tax at the beneficiary’s marginal rate.

The LSDBA is a test on certain tax-free lump sums paid during the member’s lifetime and on death before age 75. So, when testing lump sum death benefits, any tax-free lump sums paid to the member will reduce the available LSDBA. Lump sum death benefits from funds crystallised before 6 April 2024 are not tested against the LSDBA.

For more detail on LSDBA testing, see our technical guide ‘Lump sum and death benefit allowance (LSDBA)’.

Where the death benefits are used to provide a pension, it is not tested against the allowance, and it will remain tax free regardless of the size of the deceased member’s fund. Where lump sum death benefits would exceed the available LSDBA, beneficiaries would therefore be better considering beneficiary's drawdown as the whole fund will remain tax-free for the beneficiary and lump sums can be taken from the drawdown funds at any time.

Inheritance tax can also be another motivation for considering beneficiary's drawdown. It's not unusual for couples to nominate everything to the survivor on the first death, but this might not be the most tax efficient option.

If paid as a lump sum to the survivor, it will form part of their estate for IHT. Beneficiary's drawdown keeps pension funds under the pensions regime and therefore outside the estate for IHT. However, the tax treatment of the death benefits from the beneficiary's drawdown on second death may be based on the age of the survivor when they died.

This means, for example, that where the original member died before age 75 and their spouse inherits the funds as beneficiary's drawdown, any withdrawals will be free of income tax. But if the spouse then dies after reaching age 75, the tax position changes and the benefits paid to their beneficiaries will then be subject to income tax. 

Taxation of death benefits post-75

If death is after age 75, the death benefit is taxable at the beneficiary's marginal rate (or 45% if paid to a trust).

• Lump sums will be added to the beneficiary's other income in the tax year and taxed at the appropriate rate
• Beneficiary's drawdown is only taxed when the beneficiary withdraws income from their inherited pot.

Making nominations, therefore giving all beneficiaries the lump sum and pension options can help reduce the amount of tax payable.  

By accessing as a lump sum, the whole amount is assessed in a single tax year with only one personal allowance available and the potential of paying tax at a rate higher than they would normally expect to.

Using beneficiary's drawdown means that tax can be spread across many tax years. The beneficiary has some control over when withdrawals are taken to maximise tax allowances and limit the amount of tax payable.

Nominating a bypass trust

A bypass trust allows a member to select their own trustees who are more likely to fully understand their situation and carry out their wishes. Paying lump sum death benefits to a trust allows the member's chosen trustees to determine how the lump sum is eventually distributed. This additional control may be welcome for those with a more complicated family situation, such as where there are children from a previous marriage or relationship.

Taxation of lump sums paid to a bypass trust after age 75

Lumps sums paid to a trust are free of income tax if death is before age 75 provided it is within their available LSDBA.  However, the pension provider has to deduct tax at 45% if death is after this age. The tax suffered is available as a credit when the bypass trustees pay money to a beneficiary. It is treated as income in the hands of beneficiary with a reclaimable tax credit.

The credit for the tax already paid is intended to put bypass trusts beneficiaries in a similar position as if they had received beneficiary's drawdown. However, the amount available for the trustees to invest is only 55% of the death benefits and this will affect the investment returns within the trust and ultimately what the beneficiaries may receive.

Nominating a charity

Death benefits can only be paid to a charity if the member has nominated one. The scheme administrator cannot use their discretionary powers to pay money to a charity - discretion can only be used to pay to individuals or trusts.

Making a nomination

There is no prescribed way to make a nomination. Most pension providers will have a standard nomination form available for members to complete, but many will also accept a letter from the member explaining their wishes regarding the death benefit.

Whatever way the nomination is made, the wording should make the members wishes as clear as possible, so that the trustees/administrators understand what the member would like to happen in the event of death.

Scheme members wanting to give their beneficiaries the option to take income drawdown should name them. Nominating a class of individuals - for example, grandchildren - may not be sufficient to allow both lump sum and beneficiary's drawdown options.

If a member loses mental capacity, their attorneys cannot complete a nomination on their behalf. 

Binding nominations

Some pension schemes allow a binding nomination. This removes the scheme trustees/administrators discretion and gives added comfort that the lump sum will be paid as instructed.

However, where binding directions are available, there are typically restrictions on who the scheme member can nominate. To avoid IHT potentially becoming payable this will be limited to:

• A bypass trust - there are no IHT consequences of making a binding nomination to a trust as long as the trust excludes payments to the settlor's estate.
• The member’s spouse or civil partner – nominating an individual will generally mean the pension death benefits are included in the member’s estate for IHT unless it's covered by the spousal exemption.

Most binding nominations can still be revoked by the scheme member if circumstances change.

Reviewing and changing nominations

A nomination (even a binding one to a bypass trust) can generally be changed at any time, simply by completing a fresh nomination. The scheme administrators/trustees will use the most recent instruction they hold when determining how benefits are to be paid.

It makes sense to regularly review nominations to make sure that they continue to reflect the scheme member's wishes as circumstances can often change.

Reviewing nomination at age 75

The change in the taxation of death benefits from age 75 may also act as a prompt to review nominations. Death benefits can no longer be paid tax-free either as a lump sum or pension, once the member reaches their 75th birthday.

In particular, where someone has nominated a bypass trust there will be a 45% tax charge when the lump sum is paid to the trust. The scheme member will need to consider if the tax charge is a price worth paying for the additional control and certainty that a bypass trust can provide - although the beneficiaries are able to use the tax deducted as a credit against their own income tax liability when they receive payments from the trust.