What are death benefits?
This is the term given to any money which is payable from your pension after you die. With defined contribution pensions such as SIPPs, paying death benefits will involve distributing any money which is left in your pension when you die.
What is a beneficiary?
A beneficiary is any person (or charity, trust, organisation etc.) who may be able to receive death benefits from your pension.
What is an expression of wishes?
In most pensions, the scheme administrator has the final say over who receives the death benefits of your pension. This is part of the structure which allows your pension to stay outside of your estate for inheritance tax purposes and normally can’t be changed.
However, the scheme administrator still wants to distribute the death benefits in the way you would have wanted. An expression of wishes is your way of telling your scheme administrator who you would like your beneficiaries to be.
What are dependants, nominees and successors?
Some death benefits options are only available to beneficiaries if they fit into one of three categories.
The first category is a dependant. A dependant is a beneficiary who had any of the following relationships with a deceased pension scheme member:
- Spouse or civil partner
- Child under age 23
- A child 23 or over and dependent on the deceased due to physical or mental impairment
- Another individual dependent on the deceased due to physical or mental impairment
- Another individual who was financially dependent on the deceased, or in a mutually dependent financial relationship.
The second category is a nominee. A nominee is a beneficiary of a deceased pension scheme member who is not a dependant, but has been chosen to be a nominee by the deceased (i.e. named on their expression of wishes). Beneficiaries can also be chosen to be nominees by pension scheme administrators, but only if the deceased hadn’t made an expression of wishes and didn’t have any dependants.
The third category is a successor. A successor is a beneficiary of someone who died holding a pension made up of death benefits, who has been chosen to be a successor by the deceased on their expression of wishes. Beneficiaries can also be chosen to be successors by pension scheme administrators, but only if the deceased hadn’t made an expression of wishes.
For example, if Mr A died and his pension passed to Mrs A, Mrs A would be a dependant. If she then died and there were still some funds remaining, she could pass the funds to her daughter, Mrs B. Mrs B would be a successor. If Mrs B then died and there were still funds remaining which passed to Mr B, Mr B would also be a successor, because the funds he receives weren’t originally Mrs B’s.
What kinds of death benefits are there?
In defined contribution schemes such as SIPPs, there are normally three types of death benefits: lump sums, annuities, and drawdown.
How do lump sum death benefits work?
Lump sums are available to any beneficiary (including entities such as trusts and charities) and in any situation. A lump sum death benefit simply involves making a one-off payment to the beneficiary of their share of the death benefits. The funds are removed from a pension environment and are held by the beneficiary. If the beneficiary is a person, this means that the funds would count towards their estates for inheritance tax purposes if they were to die, unless they made other arrangements for the funds.
How do beneficiaries’ annuities work?
An annuity is a regular income which is normally paid for life. In a defined contribution pension, where the death benefits involve distributing the remaining funds in the pension, a beneficiary may have the option to use their share of the funds to purchase an annuity.
Annuities are not available to beneficiaries which are trusts, charities or other organisations: they are only available to individuals. They also may not be available if the beneficiary was not a dependant or wasn’t named on the deceased’s expression of wishes.
How does beneficiaries’ drawdown work?
Beneficiaries’ drawdown allows a beneficiary to keep their share of the death benefits within a pension. They can invest the funds as they choose and take income payments as and when required, much as they would be able to do with their own pension benefits except there is no minimum age for withdrawing the income.
Beneficiaries’ drawdown is only available to individuals: it can’t be set up for trusts, charities or other organisations. It may not be available if the beneficiary was not a dependent or wasn’t named on the deceased’s expression of wishes.
How are death benefits taxed?
If you die before age 75 and your death benefits are distributed to your beneficiaries within two years, the beneficiaries will not pay any income tax on the money they receive. However, the benefits will need to be tested against your remaining lifetime allowance, so your beneficiaries may have to pay a lifetime allowance excess charge. There may be an exception if the death benefits are being paid to a charity.
If you die age 75 or over, or if you die before age 75 but it takes longer than two years to distribute the death benefits, then the funds will be taxable. If the death benefits are being paid to individuals, they will pay tax at their marginal rates of income tax. This means that a beneficiary receiving a lump sum may end up paying more tax than one who buys an annuity or goes into drawdown, as the amount they receive will be taxed in one go. In drawdown or with an annuity, income tax is only due as and when the beneficiary receives income.
If a taxable lump sum is paid to a trust, charity or other organisation, there will normally be a flat tax charge of 45%. If you named a charity on your expression of wishes and had no dependants, the payment to the charity will still be tax free.
If the lump sum is made to a trust, individuals who receive payments from the trust are able to reclaim the 45% tax charge, and then pay income tax on the whole amount. This means they should be in the same position as if they had received the money directly from the pension.