One of the key advantages of personal pension plans is that they can be inherited.
However, as a consequence of a recent change to the UK pensions legislation, if you don’t understand the process for nominating your pension for someone else to inherit, there can be painful unintended tax consequences.
As is the case with most pensions related matters, this is a complicated subject and so this article only aims to give a basic overview.
The relevance of death before and after age 75
If someone dies before age 75, their pension can be paid out completely tax free to their chosen recipient(s).
If someone dies after age 75, the recipient of the pension has to pay income tax at their marginal income tax rate on anything they draw out from the pension.
Why is it important to be named on a death benefit nomination form?
When a pension is set up, the pension firm should request that a ‘death benefit nomination’ form is completed. The death benefit nomination form should allow you to choose what percentage of your pension you leave to whom.
Anyone who is specifically named on a death benefit nomination form is entitled to choose to receive the pension as either a one off lump sum payment or as what is called a ‘beneficiary drawdown plan’ (this is to all intents and purposes the equivalent of a pension). It does though need to be noted that some pension plans (usually old-fashioned ones) don’t have the facility to offer a ‘beneficiary drawdown plan’.
If the choice is made to receive the pension as a beneficiary drawdown plan, the recipient will only have to pay income tax on any withdrawals when they actually choose to withdraw money from the pension (and income tax is only payable if the holder of the pension died after age 75). So, for example, if your nominated recipient is still working when they inherit your pension, they might choose to leave it alone until they retire, with the objective of only drawing money out of it at a 20% income tax rate.
However, if someone who is not named on a death benefit nomination form inherits a pension (this could happen if you nominate just your spouse as the recipient and he/she dies at the same time as you, with the consequence that your children inherit instead) they are obliged to receive the inherited pension as a lump sum payment. They are not allowed to choose the option of taking the pension as a ‘beneficiary drawdown plan’. This could result in an immediate deduction of income tax at the recipient’s highest marginal income tax rate.
To illustrate this by way of example:
Scenario 1
Mr X dies in a car crash at the age of 78, along with his wife Mrs X. Mr X had completed a death benefit nomination form appointing his pension 100% to Mrs X in the event of his death. Mr X did not make any mention of his son, Mr Y on the death benefit nomination form.
When the pension firm receives a copy of Mr & Mrs X’s Wills, they see that they have chosen to leave all their assets to their son, Mr Y. Accordingly, the pension firm decides to pay out 100% of Mr X’s pension to Mr Y. But the pension firm is obliged to pay out the pension as a lump sum, less income tax at Mr Y’s highest marginal rate, because Mr Y was not specifically named on the death benefit nomination form.
Mr Y has already earned income of £150,000 in the tax year that he receives the pension death benefit payment and the value of Mr X’s pension is £400,000. The pension firm therefore has to deduct income tax at 45% of the value of the pension payment, so Mr Y only receives £220,000, with £180,000 income tax being paid directly to HMRC.
Scenario 2
This scenario is the same as scenario 1 but with the key difference that Mr X added a note to the death benefit nomination form to say that in the event of Mrs X either predeceasing him, or dying at the same time as him, he would like his pension to go to his son, Mr Y.
Because Mr Y’s name is specifically detailed on the death benefit nomination form, Mr Y has a choice as to whether he would like to receive the pension as a taxed lump sum (as in scenario 1) or whether he would like to receive the pension fund intact as a beneficiary drawdown plan, for him to draw from in the future as and when he chooses.
Mr Y chooses to receive the pension fund intact as a beneficiary drawdown plan and he doesn’t touch it until he retires at age 65. He then starts to draw down such an amount from the beneficiary drawdown plan each tax year as will keep him within the basic rate tax band, so he only pays 20% tax on the withdrawals.
Summary
A sensible approach is to make sure that your pension death benefit nomination form doesn’t just mention your intended beneficiary (e.g. your spouse) but that it also lists out, by name, anyone else who you might want to be considered as a potential beneficiary of your pension should your intended beneficiary predecease you.
You should also check whether your pension plan is of a sufficiently modern vintage to allow your heirs to elect for a beneficiary drawdown plan rather than a lump sum payment.