Understanding pension death benefits


The pension fund you retire with will have been built up over years of hard work and saving. You’ll want to have enough money to enjoy your retirement but might also be thinking about the money you might leave behind to loved ones.

What happens to your pension funds when you pass away depends on many factors, including whether or not you’ve taken benefits, how you have taken them, and your age on death.

Thinking about the implications of the pension choice you make and looking at how pension death benefits will be paid out, if at all, is worth considering.

Who does your money go to?

Death benefits on pensions are paid out to a nominated beneficiary. This is done through your pension provider rather than through your will.

Speak to your provider to see if you already have a beneficiary listed. If not, you will usually be asked to complete an ‘Expression of Wish’ form to nominate one.

You can choose any individual or organisation, including charities, and you will normally be able to choose more than one, specifying a percentage to go to each of your chosen individuals or organisations.

Death benefits are usually paid out as either pension benefits or lump sum benefits.

The two-year rule

Where death occurs before age 75, payments will usually be tax-free if funds are designated to your chosen beneficiary within two years.

For this purpose, the two-year period begins on the day the scheme administrator was first informed of the death, or the first day the scheme administrator could first reasonably have been expected to know of it, whichever is earlier.

If benefits are not designated within two years, the result will normally be that the benefits are taxed.

How can benefits be paid?

Your chosen beneficiary will generally have three main options when you pass away, although some scheme rules will vary:

  • A lump sum

If you die before the age of 75, your beneficiaries might elect to receive your pension as a tax-free lump sum. If you have yet to take any retirement benefits, they could receive 100% of your fund.

If you die after 75, your beneficiaries will pay tax on any lump sum at their marginal rate. Depending on their earnings, this could be less than they’d pay in Inheritance Tax (IHT) if your estate is liable for it.

  • Drawdown

Your beneficiary could take a regular income via Drawdown arrangement. If you die before the age of 75 and your beneficiary chooses this option within two years of your death, they will receive income tax-free.

If you’re over 75 when you die, the income received will be added to any other income your beneficiary receives and taxed accordingly.

  • Annuity

An Annuity provides a stable and regular income and might be your beneficiary’s preferred option.

Again, if you die before the age of 75 and your beneficiary selects their preferred option within two years of your death, the income will be tax-free.

If you’re over 75 when you die, income will be taxed at your beneficiary’s marginal rate. Depending on the level of income your beneficiary receives, the tax due might still be less than would be paid in Inheritance Tax (IHT).

Test against the Lifetime Allowance (LTA)

If you were to die before age 75, any pension you have yet to take, and that is being paid to your beneficiary within the two-year period, must be tested against the Lifetime Allowance (LTA).

The LTA is a limit on the amount you can draw from all pension schemes you hold (but excluding the State Pension) in your lifetime. The LTA for the 2020/21 tax year is £1,073,100.

Any death benefit paid out over this amount is subject to the LTA charge, at a rate of 55%.

The benefits will be tested against your LTA, but it is your beneficiary who is liable to pay the charge.

Taking your pension pot last

Because money held in your pension is outside of your estate for IHT calculation purposes, you might decide not to take your pension at retirement.

By taking a sustainable amount and leaving the rest invested, or by not taking it at all, you will be able to pass on your pension wealth to the next generation in a tax-efficient way on your death.

It doesn’t matter what age your beneficiaries are. They can receive your pension benefits before the current minimum retirement age of 55. Furthermore, if they choose not to take the benefits and leave them in a pension environment, they could pass them on to their chosen beneficiary tax-free too in some circumstances.

Get in touch

If you’d like to discuss how your pension benefits will be distributed on death, get in touch. Please email info@investmentsense.co.uk or call 0115 933 8433.

Please note:

A pension is a long-term investment not normally accessible until 55. The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested. Your pension income could also be affected the interest rates at the time you take your benefits. The value of tax benefits described, in addition to the tax implications of pension withdrawals, will be based on your individual circumstances, tax legislation, and regulation which are subject to change in the future.

The Financial Conduct Authority does not regulate estate planning or tax planning.