It is important to understand what will happen to your pension pot when you die and the tax implications of passing on your pension. It all depends on what types of pension you have.
A defined benefit pension pays a retirement income based on your salary and the length of time you were a member of your employer’s pension scheme with contributions being made. These type of pensions include ‘final salary’ and ‘career average’ pension schemes.
A defined contribution pension allows you to build up a pension pot to pay you a retirement income based on how much you and/or your employer contribute and how much it grows. These include workplace and personal pensions.
What happens to defined benefit pension?
If you have a defined benefit pension, any money to be paid to your beneficiaries will be outlined in the scheme’s rules. We would advise to check with your pension administrator to find out what your beneficiaries might be entitled to when you die as the rules can vary for each scheme. When you die, your pension might be paid to a dependent such as your spouse or civil partner, your children providing they are under the age of 23 and in full-time education, your children, regardless of age, if they are mentally impaired, or anyone who was financially dependent on you when you died. The pension that your dependent receives is a percentage of the pension you were getting (or would have got if you die before your pension started being paid). Any income paid to a dependent will be taxed as earnings.
What happens to your pension pot when you die?
Lump sums
Your beneficiaries could be paid the following lump sums when you die:
A death in service lump sum is when you die while an active member of your defined benefit pension scheme and your beneficiaries might get a lump sum. This is often a multiple of your salary. This would be paid tax-free if the member died before their 75th birthday.
A defined benefit pension scheme might also pay a refund of the contributions paid by the member, if the member dies before starting to draw their pension. Again, this would be subject to the scheme’s rules. Interest might also be added to the refund of contributions under some scheme’s rules.
If your pension is being paid, there’s often a guarantee period (usually 5-10 years) and if you die within the guarantee period, a lump sum might be paid to your beneficiaries. The lump sum would usually be the value of the pension payments which are due to be paid between your death and the end of the guarantee period. Again, this would be paid tax-fee if you die before the age of 75 years old. There might also be inheritance tax too, as these payments form part of your estate.
Another option, usually occurs when the pension pot is fairly small (no more than £30,000). Dependents who are entitled to receive a pension when you die might be able to opt to receive a one-off lump sum instead of a regular income. This would be taxed at the recipient’s marginal rate of income tax.
If no money has been taken from the pension when you die, then your beneficiaries can usually withdraw all the money as a lump sum, set up a guaranteed income (an annuity) with the proceeds or, they may also be able to set up a flexible retirement income (pension drawdown).
If you set up a guaranteed income (an annuity), what is payable will depend on the options you selected with you set it up. If you set up the annuity on a joint life basis, your beneficiary will continue to receive a proportion of the income you were receiving. However, if you opted for a single life annuity, the payments would stop when you die.
If you die before you are 75 years old, anyone who inherits your defined contribution pension fund won’t pay any tax.
If you die before the age of 75, any pension that has not been accessed already will be tested against your lifetime allowance. The lifetime allowance is the limit you can build up in pension over your lifetime while still enjoying the full tax benefits. Currently the lifetime allowance is £1,073,100, this will remain at this level until 5 April 2026. If this allowance is exceeded, a tax charge must be paid on the amount above the allowance.
If you die after 75, anyone who inherits your pension will be taxed on any income received as earnings at their marginal rate of income tax. No lifetime allowance tests will be carried out if you die after age 75.
State Pension
What happens to your state pension pot when you die? When you die, your state pension will stop being paid. There are a few situations where your spouse or civil partner might inherit some of your State Pension. The rules on inheriting a State Pension are complex.
If you would like to discuss your pension in more detail then please get in touch.