How Will My Pension Fund be Taxed When I Die?

This article considers changes to the taxation of income drawdown pension funds and retirement annuities, and asks some key questions that should help you identify whether your arrangements need to be reviewed.

The issue of Pension Death Benefits is becoming of greater importance as more people of retirement age enter Income Drawdown plans rather than buy an annuity with their pension fund: drawdown plans are designed to provide more attractive death benefits in later life.

Payment of death benefits from pension arrangements

In the past many advisers have advised their clients well by recommending that, in the event of the client’s death, monies payable from pension arrangements are directed to a spousal bypass trust instead of direct to beneficiaries. This tended to be good planning as it potentially avoided funds going automatically - and free of inheritance tax - to a surviving spouse, only for the funds then to be caught by inheritance tax on the subsequent death of the spouse. By using the spousal bypass trust the funds could go tax free to the trust, from where they could be accessed by the beneficiaries (including the spouse) in an extremely tax-efficient manner.

Since the recent changes to pensions were introduced, however, using a spousal bypass trust is no longer necessarily the best way to shelter the funds from tax.

What tax is payable?

If death occurs before age 75 the pension monies are now payable totally tax free – whether they are paid direct to beneficiaries or to a spousal bypass trust.

However, with effect from April 2016, if death occurs after attainment of age 75, income tax will be payable as follows:

• If paid to an individual, at their marginal rate of income tax (presently 20% for a basic rate taxpayer)
• If paid to a trust, at a rate of 45%.

Note that the income tax rate if death occurs at age 75 or later is 45% in the tax year 2015/16 irrespective of how the pension monies are paid.

What's the best thing to do?

A spousal bypass trust is still beneficial up to age 75 - and we strongly recommend that it be considered in certain situations - but, thereafter, we tend to recommend that any death benefit is paid direct to nominated beneficiaries.

Ask yourself these questions:

• When did I last review my pension’s death benefit nomination?
• Is my 75th birthday approaching?

Given the changes to pension death benefit taxation, now may be the time to review your nomination. If that big birthday is on the horizon, there is even more reason to review your arrangements.

If you would like to discuss this aspect of your financial and retirement planning, we would be delighted to hear from you.