Tony Wickenden: The truth about death benefits

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Last week I ranted about the difference between the headlines ascribed to financial changes announced by the Government and the detail set out in resulting legislation.

I picked on the ‘abolition’ of tax on death benefits, the residence nil-rate band and the reduction in tax-relievable pension contributions made by high earners.

All these gave rise to relatively simple headlines but the legislation and guidance implementing them are anything but straightforward. In the case of the death benefit changes and the residence nil-rate band, the legislative detail revealed that what was stated in the initial announcement was, at best, misleading and, at worst, a lie.

I started to look at the rules for the disposal and taxation of pension death benefits, so I am going to continue that this week.

The divergence from the simplicity of the message announcing the change is stunning. People will have taken from it that death benefits could be paid in the form of a lump sum or drawdown, or as some form of annuity to pretty much anybody, and the payments would be tax-free. Not so.

Before the pension freedoms were announced, death benefits could be paid as a lump sum to one or more of a wide range of individuals specified in the scheme rules. Typically, the member would have had the ability to make a non-binding ‘nomination’ or ‘expression of wishes’ setting out who they would like to benefit. The scheme administrator would take this into account when making a decision as to who to pay benefits to but they would not be bound to follow the nomination or expression of wishes. This is because it is important the pension fund is not treated as an asset in the estate of the member for inheritance tax purposes.

This outcome can only be achieved if it is clear the member does not have the ‘freedom to dispose’ of the pension fund on death. Being able to indicate who they would like to benefit does not satisfy this condition. As long as death benefits cannot be paid into the estate of the member, so their personal representatives can determine who would benefit by carrying out the terms of the member’s will, all should be well on this front.

Pension scheme providers uncomfortable with this responsibility have incorporated ‘integrated trusts’ into their rules. In this case, the scheme administrator would effectively abrogate their responsibility to choose the beneficiaries of the lump sum death benefits to the trustees of the integrated discretionary trust. These trustees would be appointed by the member.

What about pre-6 April 2015 death benefits for beneficiaries of a deceased member? It is important to understand this in order to understand the position for post-5 April 2015 death benefit payments. Well, until 6 April (as well as lump sums) only dependants’ drawdown could be paid. The HMRC (Pensions Tax Manual) definition of dependant for this purpose is as follows.

  • A person who was married to, or a civil partner of, the member at the date of the member’s death is a dependant of the member. Additionally, if the rules of the pension scheme so provide, the above test can be extended to apply not only at the date of the member’s death, but to extend to the point in time when the member first became actually entitled to a pension under the pension scheme.
  • A child of the member (including a legally adopted child) is a depen-dant of the member if the child:
    – Has not reached the age of 23
    – Has reached age 23 and, in the opinion of the scheme administrator, was at the date of the member’s death dependent on the member because of physical or mental impairment
    – Has reached age 23 but is covered by any of the transitional provisions described in PTM071000.
  • A person who was not married to the member or was not in a civil partnership with the member at the date of the member’s death and is not a child of the member is a dependant of the member if, in the opinion of the scheme administrator, at the date of the member’s death the person was:
    – Financially dependent on the member
    – The person’s financial relationship with the member was one of mutual dependence
    – The person was dependent on the member because of physical or mental impairment.

Typically, the member would have had the power to express a preference for the type of benefit to be paid as well as who should receive it. The scheme administrator would take those wishes into account when decision-making.

  • Finally, of course, if the member was in receipt of an annuity there could be a continuing survivor’s annuity if the member elected for the original annuity to be on a joint life and survivor basis with their spouse/civil partner. Another option was some form of guaranteed period (up to 10 years) or capital/value protection.

Tax needed to be considered in relation to all these options. Broadly speaking, lump sums would be IHT free and with no income tax if paid from a pre-crystallised fund but with tax at 55 per cent if paid from a post-crystallised fund (including any fund paid after the member’s death at age 75 or over). Any dependant’s drawdown or continuing annuity would be taxed as pension income of the recipient and any capital sum/value protection from the annuity treated as part of the inheritance-taxable estate of the member.

Having looked at the pre-6 April 2015 position in relation to who could receive what benefits and how they were taxed, I now need to look at the changes made to determine what the position is now. That is for next week and, depending how that goes, possibly the week after.

Tony Wickenden is joint managing director of Technical Connection