Changes to death benefit rules

These FAQs are for financial advisers only. They mustn’t be distributed to, or relied on by, customers. They are based on our understanding of current legislation, which may change.

How did the taxation of death benefits change?

The way death benefits are taxed changed on 6 April 2015. The rules for payments made before 6 April 2015 and payments made on or after 6 April 2015 are shown below:

These substantial changes to the death benefits rules are likely to result in many dependants and beneficiaries benefiting from paying less tax on their loved ones’ pension savings when they die.  

Pensions Technical Services

Benefit type Payment made before 6 April 2015 Payment made on or after 6 April 2015
Uncrystallised, member dies before age 75 A lump sum up to the limit of the deceased’s remaining lifetime allowance was paid tax free. The beneficiary can:
  • take a lump sum up to the limit of the deceased’s remaining lifetime allowance, paid tax free*, or
  • take tax free income from flexi-access drawdown, or
  • buy an annuity with payments paid tax free.
Uncrystallised, member dies on or after age 75 A lump sum death benefit taxed at 55% was payable. The beneficiary can:
  • take income from flexi-access drawdown taxed at their marginal rate, or
  • buy an annuity taxed at their marginal rate, or
  • take a lump sum taxed at 45% if paid before 6 April 2016 or at the recipient's marginal rate** if paid after 5 April 2016.
Crystallised (drawdown), member dies before age 75 The dependant could have:
  • continued in drawdown, or taken an annuity taxed at their marginal rate, or
  • taken a lump sum death benefit taxed at 55%.

(If there were no dependants, a lump sum less 55% tax would normally have been paid).

The beneficiary can:
  • take income from flexi-access drawdown tax free, or
  • buy an annuity, which will be paid tax free, or
  • take a tax-free lump sum*.
Crystallised (drawdown), member dies on or after age 75 The dependant could have:
  • continued in drawdown, or taken an annuity taxed at their marginal rate, or
  • taken a lump sum death benefit taxed at 55%.

(If there were no dependants, a lump sum less 55% tax would normally have been paid). 

The beneficiary can:

  • take income from flexi-access drawdown taxed at their marginal rate, or
  • buy an annuity taxed at their marginal rate, or
  • take a lump sum taxed at 45% if paid before 6 April 2016 or at the recipient's marginal rate** if paid after 5 April 2016.

* A lump sum death benefit is only paid tax free if it’s paid within a two year period. Please see the next section for more information on this.

** Lump sum payments made to 'non-qualifying persons' will still be taxed at 45% if paid after 5 April 2016. Typical examples could be lump sum payments to a trust or to a member's legal personal representatives. 

Importantly, it’s the date of the first payment of death benefits that determines the tax to be deducted, rather than the date the member dies. For example, Andrew died on 31 December 2014 aged 72 and his wife Mary decided to wait until 6 April 2015 before taking a lump sum from Andrew’s drawdown plan. Because the payment was made after 5 April 2015, the lump sum is paid to Mary tax free (regardless of the fact that Andrew died before 6 April 2015).

Before 6 April 2015, scheme administrators had to make sure they paid out any lump sum death benefits from uncrystallised funds within two years of the date they were first notified of a member’s death (or within two years of the date they could have first reasonably known of the member’s death, if earlier). Failure to pay within two years meant that when the lump sum was finally paid, it was an unauthorised payment and a tax charge applied.

From 6 April 2015, payment of an uncrystallised funds lump sum death benefit outwith the two-year period is not an unauthorised payment. It is simply subject to the special lump sum death benefit charge. The tax charge was a flat rate of 45% from 6 April 2015 to 5 April 2016 but changed to the recipient's marginal rate from 6 April 2016. Although, lump sum payments made to 'non-qualifying persons' will still be taxed at 45% if paid after 5 April 2016. Typical examples could be lump sum payments to a trust or to a member's legal personal representatives.

The above two-year rule also applies to lump sum death benefits paid from crystallised funds if the member dies before age 75. A special lump sum death benefit charge applies to any drawdown pension fund lump sum death benefit or flexi-access drawdown lump sum death benefit paid outwith the two-year period, where the member, dependant, nominee or successor dies before the age of 75. Again, the tax charge was a flat rate of 45% from 6 April 2015 to 5 April 2016 but changed to the recipient's marginal rate from 6 April 2016. Again, though, lump sum payments made to 'non-qualifying persons' will still be taxed at 45% of paid after 5 April 2016. Typical examples could be lump sum payments to a trust or to a member's legal personal representatives.  

This means that lump sum death benefits paid from crystallised funds where the member, dependant, nominee or successor died before age 75 will only be tax free if it’s paid within this two-year period.

Changes were introduced from 6 April 2015 to who can receive drawdown income from death benefits when a member dies. Before 6 April 2015, income from death benefits could only be paid to a dependant of the member, but this was relaxed from 6 April 2015 to allow pension death benefits to be paid to dependants, ‘nominees’ or ‘successors’.

A nominee can be any individual other than a dependant, who is nominated by the member (or where there are no dependants and no individual or charity has been nominated by the member, any individual nominated by the scheme administrator).

A successor is someone who inherits any unused drawdown funds (but not uncrystallised funds) on the death of a dependant, a nominee or another successor. Successors are individuals (who can also be dependants of the member) who have been nominated by a dependant, nominee or successor of the member, or if no nomination has been made, nominated by the scheme administrator. (Note - members can’t nominate successors).

There is no limit on the number of successors who can benefit from unused drawdown funds. This means it’s possible to pass unused drawdown funds through multiple generations when dependants, nominees or previous successors die.

For example, Joan, who had a flexi-access drawdown arrangement, died at age 75 on 1 May 2015, with £300,000 of unused drawdown funds left. Before she died, she nominated her younger sister Beth as a ‘nominee’. When Joan died, Beth designated the death benefits into a flexi-access drawdown and is able to draw income from the arrangement if she wants to. If she does take income, it is taxed at her marginal rate (because Joan was 75 when she died).

However, Beth is independently wealthy and still working, so she decides not to take any income. Instead she nominates her grandson as a ‘successor’, and when she dies, he can designate the remaining funds into flexi-access drawdown in his own name and choose whether to take income, leave the funds invested until a future date, or pass them on to the next generation of his family. If Beth dies before age 75, her grandson would be able to take income free of tax, but if she was 75 or over at death, tax would be due on any income at his marginal rate.

Both nominee’s and successor’s drawdown must be flexi-access and can be paid either as:

  • Nominee’s/successor’s income withdrawal, or
  • Nominee’s/successor’s short-term annuity.

It’s only possible to designate funds to a nominee’s drawdown fund from 6 April 2015, and the money must come from the deceased’s member’s capped or flexi-access drawdown fund, or from any uncrystallised funds remaining on death.

The position is similar for successor’s drawdown except that it’s not possible to designate uncrystallised funds into a successor’s drawdown fund – only unused crystallised funds can be applied to a successor’s drawdown fund.

Here’s a table that shows how annuities are impacted following the death of the annuitant, from 6 April 2015:

Benefit type Payment made before 6 April 2015 Payment made on or after 6 April 2015
Joint-life annuity, individual dies before age 75 Dependant’s annuity payments are taxed at their marginal rate of tax. Any beneficiary can receive payments tax free if the individual dies before age 75, on or after 3 December 2014.
Joint-life annuity, individual dies on or after age 75 Dependant’s annuity payments are taxed at their marginal rate of tax. Any beneficiary can receive payments at their marginal rate of tax.
Guaranteed term annuity, individual dies before age 75 Payments are made to a beneficiary at their marginal rate of tax. Any beneficiary can receive payments tax free*** if the individual dies before age 75, on or after 3 December 2014.
Guaranteed term annuity, individual dies on or after age 75 Payments are made to a beneficiary at their marginal rate of tax. Any beneficiary can receive payments taxed at their marginal rate (no change)***.
Annuity-protection lump sum death benefit, individual dies before age 75 55% tax charge. Any beneficiary can receive payments tax free.
Annuity-protection lump sum death benefit, individual dies on or after age 75 55% tax charge. Marginal rate****.

It’s worth noting that if an individual dies before the age of 75 with uncrystallised funds or unused drawdown funds remaining, then any payment of a dependant’s annuity bought with these funds will be paid tax free, so long as payment is made within two years of notification of death. If the payment is made outwith the two-year period, the payments will be taxable at marginal rate.

*** If the remaining instalments under a guarantee term are £30,000 or less, they can be paid as a trivial commutation lump sum death benefit.

**** The Government changed this from a flat rate of 45% to the recipient’s marginal rate from 6 April 2016.

BCE5C and BCE5D were introduced from 6 April 2015.

BCE5C is used when a member dies before age 75 and their remaining uncrystallised funds are designated for dependant’s or nominee’s flexi-access drawdown within the two year period mentioned above. The amount tested against the deceased member’s lifetime allowance is the amount that’s designated, and the liability for any charge that arises falls on the dependant/nominee.

BCE5D is used when a member dies before age 75 and their remaining uncrystallised funds are used to purchase (in whole or in part) a dependants’ or nominees’ annuity within the two year period mentioned above. The amount tested against the deceased member's lifetime allowance is the purchase price of the annuity, and the liability for any charge that arises falls on the dependant/nominee.

This article covers all the changes that affect the different types of death benefits that could be payable from 6 April 2015. Schemes aren’t obliged to offer all options in practice though, so it’s important to check what is available from each scheme with the relevant provider.

Conclusion

These substantial changes to the death benefits rules are likely to result in many dependants and beneficiaries benefiting from paying less tax on their loved ones’ pension savings when they die. 

Pensions Technical Services