Since the introduction of pension freedoms in 2015, death benefits have become more generous, particularly if the member passes away before age 75.
This entailed tax-free benefits and the option to keep the money in a tax-free pension wrapper.
What’s changing from April 2024?
Last year, draft legislation to remove the Lifetime Allowance (LTA) suggested that where death benefits are kept in the tax-free wrapper, they may become taxable when taken out. This applied even if the person who passed the pension benefits down died before their 75th birthday.
This represented a significant loss of tax-free benefits. The good news is that this is not happening. However, as we bid farewell to the LTA and welcome the “lump sum and death benefit allowance (LSDBA),” there are some tweaks to consider when a member dies before 75.
What are the rules now on death benefits?
The LSDBA is set at £1,073,100, the same as the current LTA, but it operates differently. Under this new system, only lump sums are tested, and any money kept in the tax-free wrapper is ignored.
To provide an example, suppose a member passes away at the age of 70. Before passing, they had taken a £150,000 Pension Commencement Lump Sum (PCLS) and had initially invested £450,000 into drawdown. At their death, their drawdown fund had grown to £500,000, and they had £600,000 of uncrystallised funds available. Under the old LTA rules, only the uncrystallised pot would be compared to the available LTA, and there would not have been a charge. After April 2024, the £150,000 PCLS reduces the available LSDBA to £923,100 for death benefits. However, both crystallised and uncrystallised pots are tested for lump-sum death benefits. As the remaining fund exceeds the available LSDBA by £176,900, this money would be subject to income tax.
How can I ensure I stay on the right side of these rules?
It is important to note that if beneficiaries choose to receive their inheritance as a lump sum, any excess amount over the tax-free threshold will be subject to income tax. On the other hand, if they opt for regular income payments, the amount received will be tax-free. Therefore, it is crucial to nominate beneficiaries correctly. Dependents always have the option to receive regular income payments, whereas non-dependents, such as adult children, must be nominated to be eligible.
An example would be a wealthy couple where one spouse is nominated but doesn’t need the income. If their adult children were not nominated, they would be left with only the lump-sum option. The tax difference could be substantial.
