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Death benefit options

When an individual dies with funds in a money purchase pension scheme, the trustees or scheme administrators of a money purchase pension will normally* have discretion over who receives death benefits. If the member had completed a nomination form (or made a letter of wishes), this will help them with their decision making.

* Nobody has discretion over who should receive death benefits from a Section 32 or Retirement Annuity Contract - instead, they're paid directly to the estate of the deceased or to named individuals. Due to the lack of discretion, this can sometimes have IHT consequences. Please see our 'Pensions and IHT' guide for more information, including how any potential IHT liability can be avoided.

There is a range of ways in which death benefits can be provided for beneficiaries. The choice is not necessarily all or nothing - the same pension pot may provide benefits in different ways. These include:

• lump sum
• income drawdown
• lifetime annuity
• dependant's scheme pension

Individuals potentially have the choice of a lump sum, or a pension via income drawdown, a lifetime annuity or a dependant's 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. Also, a lack of a nomination can sometimes restrict the options available to non-dependants.

Survivors may also be entitled to other death benefits associated with the member's pension, over which they have less control. For example:

• ongoing annuity payments where joint life annuity had been purchased by the member
• benefits paid under a 'guarantee period'
• benefits paid under 'value protection'
• a dependant's scheme pension

There are special rules which dictate the death benefits available from contracted-out rights - see our technical guides on GMP and Section 9(2B) rights for more information.

Lump sums to individuals

Any remaining funds in a money purchase pension on the death of the original member, or a beneficiary who had inherited a pension, may be paid as a lump sum. This can include both crystallised and uncrystallised funds.

The amount of the lump sum will be the value of the fund immediately before payment, plus any associated life cover (if applicable).

Taxation - lump sum

The tax treatment of the lump sum payment largely depends on the age of the deceased member at death.

Member died before age 75
Lump sums paid to an individual are generally tax-free where the member died before 75, as long as it's within two years of the scheme administrator first knowing about the member's death.

However, certain* lump sum death benefits must be tested against the deceased's 'lump sum and death benefit allowance' (LSDBA). Those in excess of the available LSDBA will be subject to income tax at the beneficiary’s marginal rate. The scheme administrator will pay the lump sum without deduction of tax and the beneficiary will need to declare it on their self-assessment.

* Not all lump sums death benefits are tested against the LSDBA – for example, some charity lump sums and death benefits from benefits crystallised before 6 April 2024. See our technical guide ‘Lump sum and death benefit allowance (LSDBA)’ for full details.  

Any lump sums paid outside the two-year period will be fully taxable as income at the beneficiary’s marginal rate.

Member died on or after age 75
Post 75, the lump sum is taxable at the beneficiary's marginal income tax rate.

Unlike pre-75 lump sums in excess of LSDBA the pension provider must deduct tax under PAYE. Often, where the beneficiary's own tax coding is not available, this may involve the use of an emergency tax code and the beneficiary may need to reclaim any overpayment of tax directly from HMRC. See our guide 'Pensions and emergency tax' for more detail.

Once outside of the pension wrapper, lump sum death benefits will form part of the beneficiary's estate for IHT.

Inherited drawdown

On the death of the original member, or a beneficiary who has inherited a pension, any remaining money purchase funds can be passed on to their beneficiaries. 

Flexi-access drawdown is one of the ways a beneficiary can use an inherited fund. If chosen, it will allow:

• funds to remain in the pension scheme under an arrangement set up for the beneficiary
• the beneficiary to draw what they need from this pot at any time until the fund is exhausted, or until the fund is used to buy an annuity
• the beneficiary to nominate who they'd like to benefit from any remaining funds when they die. In this way it's possible for pension savings to pass down through generations

Drawing income from inherited pension funds does not trigger the money purchase annual allowance (MPAA), so it doesn't restrict the beneficiary's ability to fund pensions. (Drawdown income does not, of course, count towards relevant UK earnings, but will still count towards adjusted and threshold income for annual allowance tapering purposes).

Beneficiaries

Death benefits in the form of drawdown can be paid to individuals. But it's not possible to set up drawdown arrangements for other bodies, such as charities or trusts.

Ultimately, the scheme administrators will usually have discretion over who benefits, but it's only possible for a beneficiary to take their funds under drawdown if the scheme in question offers drawdown and either:

• the beneficiary is a dependant or has been nominated by the deceased, or
• if not, there are no dependants (on the death of the original member only) and no other nominations have been made by the deceased.

There are no age restrictions on who can have a drawdown arrangement or when benefits can be taken. For example, someone under the age of 55 can still make withdrawals.

Drawdown arrangements can be created for minors. Any withdrawals must be made by a person with parental responsibilities towards the child and applied for the child's benefit. There's no longer a requirement for drawdown payments to minors to stop at age 23.

Taxation - inherited drawdown

Funds taken under inherited drawdown are not tested against the LSDBA.

The tax treatment of a beneficiary's drawdown payments starting on or after 6 April 2015 largely depends on the age of the deceased member at death.

Death before age 75
The payments can normally be paid tax free. However, payments from any uncrystallised funds will only be tax free if the funds are designated for drawdown within two years of the scheme administrator first knowing about the member's death. This doesn't apply to funds already crystallised.

The designation of uncrystallised funds outside the two-year period will result in the payments being taxed as income on the recipient at their marginal rate.

Dependant's drawdown payments which started before 6 April 2015 will continue to be subject to income tax.

Death on or after age 75
Any drawdown payments are taxable on the recipient at their marginal rate.

As the taxation depends on the age at death of the last owner of the fund (i.e. the original member or subsequent beneficiaries) it's possible for withdrawals from an inherited fund to be taxed differently as it passes to new beneficiaries on successive deaths.

If withdrawals are subject to income tax, they will be added to the beneficiary's other non-savings income such as state pensions, private pensions, salary and rental income and taxed at the appropriate rate, after the deduction of any personal allowance.

Tax on withdrawals will be collected by the pension provider under PAYE. Initial ad-hoc payments will usually be taxed using an emergency code on a month 1 basis until HMRC has informed the provider of the correct tax code to apply to subsequent payments. This may result in an overpayment of income tax, but this can be reclaimed using the appropriate forms. See our guide 'Pensions and emergency tax' for more detail.

Keeping funds within the pension tax wrapper will have certain benefits:

• the beneficiary will benefit from any investment growth
• inherited funds within a pension won't be included in a beneficiary's estate for inheritance tax
• there will be no further tax on investment income and gains received by the pension scheme fund managers.

Asset control

The tax benefits of retaining inherited pension funds within a pension are clear.

However, some individuals may have concerns over who their funds may pass to in the future, as it's always the right of the last owner of the funds to nominate who should benefit next. This means the funds could ultimately end up in the hands of someone the original member would not have chosen.

Lifetime annuity

A lifetime annuity can be an attractive option for beneficiary who needs a secure level of income. This involves using the deceased's pension fund to buy an annuity contract from an insurance company which will provide the beneficiary with a regular income for life. This could be using the deceased member's uncrystallised funds, or any remaining income drawdown funds following the death of the last owner.

If a beneficiary has initially chosen income drawdown, it's possible to use the drawdown funds at any time to buy an annuity.

Beneficiaries 

Since 6 April 2015, a lifetime annuity can be used to provide a pension for any individual (not just dependants) - irrespective of their age. But, unlike the position under income drawdown, dependants' annuities for children must still stop at age 23 (unless, for example, they're still dependant because of physical or mental impairment).

However, like income drawdown, it's only possible for a beneficiary to have an annuity if:

• the beneficiary is a dependant or has been nominated by the deceased, or
• if not, there are no dependants (on the death of the original member only) and no other nominations have been made by the deceased.

Income options

The level of pension paid will depend on the fund value, the pension options chosen and the current annuity rates available from the chosen annuity provider. The annuity rates will typically be determined based on prevailing interest rates and the pensioner's age and life expectancy.

• Payment frequency - payments must be paid at least once a year but, other than this, there are no restrictions on the payment frequency. So they could be paid weekly, fortnightly, monthly, quarterly or yearly. And they can be paid in advance or in arrears.
• Pension increases/decreases - the annuity can be set up to pay a level, increasing or even a decreasing income. An increasing pension can help protect the pension's real buying power against the effects of price inflation. A decreasing annuity for a beneficiary (in contrast to one for the original member) will not trigger the money purchase annual allowance.
• Guarantee/annuity protection/survivor's pensions - unlike when the original member is setting up a lifetime annuity, it's not possible to attach these options to a beneficiary's lifetime annuity.

A survivor's pension can be paid on the member's death because the member had bought a joint life annuity - this means that, on their death, the pension (or a proportion of it) could continue to a specified survivor.

Or there could be continuing pension payments because the member's annuity was set up with a pension guarantee. These can be paid to anyone.

Taxation - lifetime annuity

The tax treatment of beneficiaries' annuity payments starting on or after 6 April 2015 largely depends on the age of the deceased member at death.

Death before age 75
The pension can normally be paid tax free. However, if the funds used to buy the annuity were at least partly from uncrystallised funds, it will only be tax free if:

• the date of death was after 2 December 2014 and
• the entitlement to the annuity arose within two years of the scheme administrator first knowing about the member's death (or when it could first reasonably have been expected to know of it).

If these conditions are not met, the annuity payments will be taxed as income on the recipient at their marginal rate.

If the pension is not set up within the two-year period the income will be taxable on the recipient at their marginal rate.

If the original member had either:

• bought a joint life annuity or
• died within any guarantee period

and the survivor's payments start after 5 April 2015, they will be paid tax-free provided the date of death was after 2 December 2014.

Death on or after 75
The annuity payments are taxable on the recipient at their marginal rate.

If a beneficiary was already receiving a survivor's annuity or ongoing guarantee payments before 6 April 2015, the pension will continue to be taxed as the recipient's income.

Lump sum to a trust

A lump sum death benefit paid to trust can be an effective way of maintaining an element of control over payments to beneficiaries after the death of the member. It's the trustees of the bypass trust decide who will benefit and when. For example, this could be an attractive option if the member was concerned that a young beneficiary may inherit a large fund and spend it unwisely.

Most pension schemes will have discretion over the payment of death benefits. The scheme administrator/trustees can pay a lump sum to the trustees of an existing trust. This is typically a 'bypass trust' (this is the generic term for a discretionary trust created to receive pension lump sum death benefits) which the scheme member created during their lifetime or a trust established in their will.

Pensions such as Section 32s and Retirement Annuity Contracts don't have discretion over the payment of death benefits and therefore, the value of the death benefits is deemed part of the member's estate. The member may be able to create a trust during their lifetime and assign the right to any lump sum death benefits into it, which can avoid the potential IHT issue. However, there can still be potential IHT consequences if the member is in poor health when the death benefits are assigned to the trust.

Tax when lump sum paid to a trust

Death before age 75
Lump sums paid to trust are generally tax-free where the member died before 75, as long as it's within two years of the scheme administrator first knowing about the member's death.

However, certain* lump sum death benefits have to be tested against the deceased’s LSDBA. Those in excess of the available LSDBA will be taxed as income of the trust. This will mean the trustees of discretionary bypass trusts will need to pay a 45% tax charge on the lump sum received.

* Not all lump sums death benefits are tested against the LSDBA – most notably those paid from benefits crystallised before 6 April 2024. See our technical guide ‘Lump sum and death benefit allowance (LSDBA)’ for full details.

Lump sum death benefits paid to trust more than two years after the member died will be subject to a 45% 'special lump sum death benefits charge'. This is applied to the whole lump sum not just the excess over the LSDBA and will be deducted by the scheme administrator.

Death after reaching age 75
If the member died after reaching age 75, the scheme administrator must deduct the 'special lump sum death benefit charge' of 45% before the lump sum is paid to the trust.

There's no IHT charge when the pension death benefits are paid to the bypass trust.

Ongoing trust taxation

Once death benefits are paid to the trust, they are outside of the pension and lose the tax privileges of the pension wrapper.

Income tax and CGT - Income and gains on trust investments will be taxed according to the type of trust used. Discretionary trusts are most commonly used for this purpose and income and gains would be taxable at the trust rates - income (45% interest/39.35% dividends) and capital gains (28% residential property and 20% on all other gains).

Inheritance tax - Pensions are specifically exempt from IHT relevant property charges. But that protection from periodic and exit charges ceases once funds are no longer held for pension purposes. When a lump sum death benefit is paid to a relevant property trust, such as a discretionary trust, they'll come within the IHT relevant property regime. The trustees will potentially be subject to IHT charges every 10 years (periodic charge) and when capital leaves the trust (exit charge).

Taxation of payments from the trust to a beneficiary

How payments to beneficiaries are taxed will depend upon whether the member died before or after age 75.

Death before age 75
Lump sum death benefits will normally have been paid tax-free to the trust if it was within the member’s LSDBA. Subsequent payments by the trustees to the beneficiaries of the lump sum will be payments of capital.

These payments won't be taxable upon the beneficiary. But they are potentially subject to an IHT exit charge.

Any relevant lump sum death benefit which was in excess of the LSDBA will be taxed as income of the trust. That means the trustees of a typical discretionary bypass trust will have to pay income tax at 45% on the amount over the LSDBA.

The tax paid by the trustees will form part of the trust’s ‘tax pool’ available for use with future trust income distributions to beneficiaries (e.g. trust income arising from interest or dividends). These income distribution must be accompanied by form R185 (Trust income). This tax pool cannot be used for tax credits when distributing capital relating to the lump sum death benefit.

This is in contrast to the post 75 tax treatment where such capital payments to a beneficiary are treated as income and credit is given for the 45% special lump sum death benefit charge deducted by the scheme administrator (see below).

Death on or after age 75
Where the trustees make a distribution of the lump sum death benefit to a beneficiary, the payment is treated as the beneficiary's income for tax purposes rather than capital.

The 45% special lump sum death benefit charge deducted when the lump sum was paid to trust is available to act as a credit against the payment the beneficiary receives. The trustees will need to issue an R185 (Pension LSDB) certificate to the beneficiary to show that the trust payment is paid with a 45% tax credit. The beneficiary can reclaim any overpayments of tax through their self-assessment or using an R40 (Claim for repayment of tax on savings form).

Lump sum to a charity

A charity can be nominated to receive a death benefit lump sum. It's not possible for a charity to receive a pension following the member's death. The tax treatment can depend on the member or survivor's age at death.

Death before age 75
On death before age 75, lump sums paid to charity will normally be tax-ree and are not tested against the deceased member's available LSDBA so long as:

• there are no dependants
• the member had nominated the charity (the scheme administrator cannot nominate a charity)

If these conditions are not met the lump sum will be tested against the LSDBA with any excess potentially taxable if the charity is not exempt from tax.

Death after age 75
On death on or after age 75, a lump sum can only be paid tax free to a charity if:

• there are no dependants
• the member had nominated the charity (the scheme administrator cannot nominate a charity) and
• it's paid from income drawdown funds or unused funds

Lump sum death benefits paid to a charity that don't meet the criteria will be taxed at 45%.

If the death benefits are to be paid from a survivor's drawdown pot, it can be paid tax-free if:

• there are no dependants of the original member at the time of the payment and
• if the original member had failed to nominate a charity, their successor had nominated one.

Scheme pension

Scheme pensions are potentially a death benefit option from money purchase schemes but, in practice, very few money purchase schemes give that option.

And, unlike other death benefit options, scheme pensions are only available to dependants of the original member. The dependant must have been given the opportunity to choose an annuity instead.

A scheme pension is a promise to pay the individual a regular amount of income, usually for life - however, a scheme pension for a dependant can stop at any time in accordance with the scheme rules (for example, on remarriage).

Dependants' scheme pensions can be set up using the deceased member's uncrystallised funds, or any remaining income drawdown funds. They could also come into payment on death of a member in receipt of their own scheme pension, if a dependant's scheme pension had been chosen to be included at the outset.

The pension can then either be paid direct from the scheme assets or secured using a lifetime annuity. The scheme will determine the shape of pension paid. This includes the frequency of payments (which must be at least once a year), whether payments will be level or increasing, in what circumstances payments can be reduced or stopped. However, the scheme may allow the dependant to choose the payment frequency and any escalation, which could change the level of pension.

It's not possible to include a guarantee period, offer any form of value protection, or give rise to any further benefit on the death of the dependant.

If a dependant's scheme pension is paid direct from money purchase funds, the amount paid will be the scheme actuary's best estimate of what amount of scheme pension represents fair value for the amount of fund given up in return for the promised pension. The actuary's calculations will be based on the pensioner's age and best estimates of the pensioner's life expectancy and future investment returns on the funds.

Taxation - scheme pension

Dependants' scheme pensions are always taxed as the recipient's income - regardless of whether the original member died before or after age 75.

For deaths before age 75, this normally puts beneficiaries receiving a scheme pension at a disadvantage to those receiving other forms of death benefit.

Death of the dependant

On the eventual death of the dependant there could still be funds that were being used to pay the scheme pension left over. However, these cannot normally be paid out as a lump sum death benefit or reallocated to connected member's rights in the same scheme without incurring unauthorised payment tax charges of up to 70%. There is, however, an exemption for schemes with at least 20 members where all members' benefits are increased uniformly as a result of the pensioner's death.