The key points to consider when looking at how inherited pension pots are taxed.
When a member of a pension scheme dies the pension pots relating to that person may be passed on to living individuals.
Often a member of a pension scheme will start to draw their pension benefits when they retire, ie they will cease full time employment and in order to maintain their living standard they will start to withdraw benefits from their pension scheme(s). However, since 6 April 2015 legislation changes give pension scheme members options regarding when they could take benefits from their pension schemes.
Taking benefits from defined benefit pension schemes
In most cases the rules of the defined benefit pension scheme will stipulate the options available to the scheme member. Typically the options available will include:
withdrawing a pension (usually monthly payments). Often this will be reduced if started before the normal retirement date and is often enhanced if started after the normal retirement date (which will be specified in the scheme rules)
withdrawing a tax free cash lump sum (limits apply) followed by a reduced pension (usually monthly payments)
transferring the ‘pension pot’ to another pension scheme (either another defined benefit scheme or a defined contribution scheme).
When the member dies the defined benefit pension scheme rules will usually only allow a pension to be paid to a dependant (this would include a husband, wife, civil partner or child under the age of 23). This dependant’s pension may be less than the pension which the member was entitled to.
Taking benefits from defined contribution pension schemes Most defined contribution pension scheme providers will allow greater flexibility about how benefits can be withdrawn from such a scheme. Typically the options available to the member will include:
purchase annuities (these usually pay a monthly amount for the remaining life of the member) (although other individuals may be paid after the member dies)
withdrawing a tax free lump sum (limits apply)
withdrawing amounts, 25% of which is tax free and the remainder is taxed at the member's marginal rate of tax
transferring the ‘pension pot’ to another pension scheme (either another defined benefit scheme or a defined contribution scheme)
on the death of the member any remaining funds in the ‘pension pot’ will usually be paid to an individual or individuals nominated as beneficiaries of the scheme
the pension scheme provider will usually allow a member to use any combination of the above options.
When can a member make withdrawals from a defined contribution pension scheme? If the member is under 55 years of age then access to the pension pot will normally only be available if:
the member is in poor health
the member is in a profession where retirement is lower than normal (such as a professional sports person)
the member has a protected pension age lower than 55.
If the member is 55 years old or over, then that member can usually access the pension pot at any time, whether they are still working or not (although sometimes the scheme rules may stipulate otherwise).
How is the beneficiary taxed relating to a defined contribution pension scheme which they inherit? The tax treatment will depend on the age of the member when they died and the nature of the scheme at the date of that death. There is a different tax treatment if the member dies before the age of 75 as opposed to after the age of 75.
Death below age 75
1. Uncrystallised funds
The fund can be paid to any beneficiary tax free as a lump sum, annuity or as a drawdown pension.
The benefits will be tested against the lifetime allowance.
2. Crystallised (in drawdown)
The fund can be paid to any beneficiary tax free as a lump sum or as a drawdown pension. A drawdown fund can be used to buy an annuity at any time.
3. ‘Joint life annuity’, ‘Guaranteed term annuity’ or ‘Annuity with protected lump sum death benefit’
Any beneficiary can receive payments tax free.
The rule remains that tax free lump sum payments (where the member dies under 75) must be made within two years of the scheme administrator being notified of the death of the individual. However, any lump sum payments made after the two year period will no longer be an unauthorised payment (i.e. taxable at 55%). Instead they are taxed at the recipient’s marginal rate.
Payments from a joint-life annuity, or an annuity purchased from crystallised rights or unused funds remaining in a drawdown pension, must be made within two years of the scheme administrator being notified of the death of the individual, or they become taxable at the recipient’s marginal rate.
Death after age 75
1. Uncrystallised funds and Crystallised funds
The fund can be paid to any beneficiary, taxed at their marginal rate. Payment can occur as a lump sum, annuity or as a drawdown pension. The fund can be paid to a trust as a lump sum in which case a 45% tax charge will be deducted before being paid to the trust.
2. ‘Joint life annuity’, ‘Guaranteed term annuity’
Any beneficiary can receive payments taxed at their marginal rate.
3. Annuity with protected lump sum death benefit
Any beneficiary can receive the lump sum payment taxed at their marginal rate. The fund can be paid to a trust as a lump sum in which case a 45% tax charge will be deducted before being paid to the trust.
Lifetime allowance charge at age of 75 or if death occurs before age 75
If a member’s pension has not already been tested against the lifetime allowance, then when that individual dies it will be tested before being passed on to the beneficiary. Any pension funds that a person inherits will not count towards their own lifetime allowance.
However, if the member was aged under 75 when they died, and the uncrystallised funds lump sum death benefit is paid more than two years from the date the scheme administrator first knew of the member’s death (or if earlier, the date they could first reasonably have been expected to know of it), the uncrystallised funds lump sum death benefit is not tested against the lifetime allowance.
The lifetime allowance charge (LTA) only applies when the benefits in a person’s pension schemes exceed the available Lifetime Allowance following a Benefit Crystallisation Event (BCE). There are currently 13 BCEs, three of which occur when an individual reaches the age of 75 and two occur when an individual dies before their 75th birthday.
The LTA charge is applied to the amount which crystallises at a BCE over and above the member’s available LTA. The charge is applied at two different rates as follows:
55% if the excess is taken as a lump sum before age 75 (known as a LTA excess lump sum); or
25% if the excess is retained within the scheme.
Mr A has a BCE and the value of his pension schemes at that time exceeds his available LTA by £200,000. Mr A has the choice of taking the excess as:
a lifetime allowance excess lump sum of £90,000 (£200,000 x (1 – 55%)) or
£150,000 could be retained in the scheme(s) to provide Mr A with benefits in the future (but would be subject to tax under PAYE).
If an individual has a Benefit Crystallisation Event before age 75 there may be a second BCE at the age of 75.
The lifetime allowance has been as follows:
Mr B, in the tax year to 5 April 2013, withdrew a tax free lump sum of £200,000 and the remaining £600,000 was transferred to a drawdown pension scheme. Mr B had no other pension schemes. This used 53.3% of the LTA (£800,000/£1,500,000).
For that year the lifetime allowance was £1,500,000. Mr B was 70 years old in the tax year ended 5 April 2013.
Mr B has taken no income from the drawdown fund and in the year ended 5 April 2018 Mr B is 75 years old and the drawdown fund has increased in value to £1,300,000. At age 75 there is a second BCE. The crystallisation amount is the fund value less the original drawdown value at the previous BCE (£1,300,000 less £600,000 = £700,000). The lifetime allowance remaining at the second BCE is 46.6% x £1,000,000 = £466,667.
There is a Lifetime Allowance Charge on £700,000 less £466,667 = £233,333.
As the funds are retained in the drawdown scheme the charge is £233,333 x 25% = £58,333 which is deducted from the fund and paid to HMRC by the pension scheme administrators.
Other scenarios which could have occurred regarding Mr B:
If he had died before reaching the age of 75, then the funds would be paid to his nominees tax free and there would be no second crystallisation event and no LTA tax charge on death.
Mr B could have withdrawn some of the drawdown funds which would have reduced the LTA charge on his 75th birthday. For example he could have withdrawn say £200,000 over the 3 or 4 years before his 75th birthday. This would be treated as taxable income, but it may have reduced the drawdown fund to below £466,667 in which case no LTA charge would occur on his 75th birthday. However, the funds withdrawn less tax may add to his estate value at death if not spent before then.
It may suit Mr B to pay the LTA charge on his 75th birthday, especially if he does not intend to touch the drawdown funds and just wants to keep them out of his estate for inheritance tax purposes.