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Death benefits from defined contribution schemes

Author Image The Technical Team
21 minutes read
Last updated on 6th Apr 2019

Overview

Learn about the different types of death benefit, including those from defined contribution schemes, and the way they’re taxed.

Key points

  • Defined contribution schemes usually offer lump sum and income death benefits.
  • Each scheme will define the treatment of benefits on the death of a member and each scheme may be different.
  • Death benefits from occupational defined contribution schemes may not offer full flexibility of death benefits.
  • Death benefits are usually tax-free if the member dies when they are under 75, they are settled within two years of the scheme administrator becoming aware and the lump sum is within the member’s lifetime allowance.
  • Death benefits are taxable if the member dies after reaching age 75.
  • Lifetime allowance
  • Charity lump sum death benefits may be available.

Background

Legislation effective from 6 April 2015 resulted in a significant change in the options and definitions surrounding death benefits, and how they are taxed. This article focuses on the death benefits available from defined contribution schemes.

The death benefits payable are based on a number of factors. These include the type of scheme, who is to receive the benefit and how they are to be paid, if the death is before or after crystallisation and if the death is before or after age 75.

What can a defined contribution scheme legislatively offer and to whom

Defined Contribution Scheme

 

 

This diagram explains who can receive and what they can receive legislatively. However, this is when a defined contribution scheme offers the full range of flexibility. 

The type of benefits that might be offered are:

  • cash lump sums,

  • dependants’ / nominees’ / successors’ annuity

  • dependants’ / nominees’ / successors’ drawdown.

If allowed in the pension scheme's rules, it’s possible to have a mixture of death benefits and for the death benefits to be provided to more than one beneficiary.

Sections 167 and 168 and Schedules 28 and 29 Finance Act 2004

The recipient(s) of death benefits are usually chosen at the discretion of the pension scheme trustees or administrator. However, a member / pension holder can nominate whom they wish to receive the benefits, by completing a nomination of beneficiaries form (sometimes called an "expression of wish") and the trustees will usually take this into account.

It's important to note that when the funds pass to a beneficiary, following the death of a pension holder, the funds will follow the beneficiary’s choice of subsequent successor. So the original member has no control over the remaining funds and the choice for later payments after their subsequent death. The exception to this is where the original member nominated a charity which is explained later when we discuss charity lump sum death benefits.

As such, if the funds initially pass to say a spouse, the spouse can subsequently leave the money to say, the children of a later relationship (rather than the children of the pension holder). To retain a degree of control it's still possible to nominate for the death benefits to be paid to a trust. A commonly used trust to facilitate this control is a spousal bypass trust. More information can be found in our spousal bypass trusts facts article.

Before the different types of death benefit are considered, what do the definitions mean?

Definitions

What is a dependant?

The HMRC definition of a "dependant" is broadly:

  • The member's widow(er) or civil partner at the time of the member's death
  • A child of the member who is under the age 23
  • A child of the member who, in the opinion of the scheme administrator, is dependant on the member, because of physical or mental impairment, at the date of the member's death.
  • A person who wasn't married or in a civil partnership and is not child of the member, who in the opinion of the scheme administrator is, at the date of the member’s death:
    • financially dependent on the member
    • in a financial relationship of mutual dependency with the member
    • dependent on the member due to mental or physical impairment.

Paragraph 15 Schedule 28 Finance Act 2004

Pension scheme rules may restrict to a narrower definition of dependant (for example, a younger cessation age for a child's pension). The scheme rules rule.

What is a nominee?

Nominee

This is any individual who is nominated to receive the death benefits, by either the member or by the scheme administrator. A nominee is someone who's not a dependant. If the scheme is going to pay benefits as an income, the scheme can choose a nominee only where the member has no dependants and the member didn't choose a nominee. If:

  • the scheme doesn't have a nominee from the member, but
  • there is someone who qualifies as a dependant and
  • the scheme considers it inappropriate to pay to the dependant (such as in the case of an estranged spouse), the scheme can pay only a lump sum to a non-dependant, as a dependant exists.

What is a successor?

Successor
A 'successor' is an individual:

  • nominated by a dependant of the member,
  • nominated by a nominee of the member,
  • nominated by a successor of the member, or
  • nominated by the scheme administrator.

Types of death benefits

Lump sum death benefits

A lump sum may be paid on the death of the member. If the member is in drawdown then it would be a drawdown lump sum death benefit subject to the following conditions;

  • it is paid in respect of either income withdrawal (drawdown) to which a member / dependant / nominee or successor was entitled to be paid at the date of their death,
  • it is not a charity lump sum death benefit.

The maximum amount which can be paid is the total of all the assets in drawdown.

Paragraph 17 Schedule 29 Finance Act 2004

If a member has not crystallised funds yet, the lump sum will be an uncrystallised funds lump sum death benefit if it isn’t a charity lump sum death benefit.

Paragraph 15 Schedule 29 Finance Act 2004

Dependants’ or nominees’ annuity

From 6 April 2015 onwards, to be a dependants’ or nominees’ annuity, the annuity contract must either:

  • be purchased from any uncrystallised funds or drawdown fund remaining on the death of the member. It may also be purchased from the drawdown fund of the dependant concerned, or from the flexi-access drawdown of the nominee concerned; or
  • be a future dependants’ or nominees’ annuity provided for at the time the member purchased their own lifetime annuity (this is covered in detail in our article Death benefits and annuities)

Paragraphs 15(2A) and (2B), 17 and 27AA Schedule 28 Finance Act 2004

Successor's annuity

An annuity payable to a successor is a successor's annuity if:

  • the successor becomes entitled to it on or after 6 April 2015,
  • it is payable by an insurance company,
  • it is payable until the successor's death or until the earliest of the successor's marrying, entering into a civil partnership or dying,
  • it is purchased after the death of a dependant, nominee or successor of the member (the beneficiary),
  • it is purchased using undrawn funds, and
  • the beneficiary dies on or after 3 December 2014.

For the purposes of an arrangement after the beneficiary's death, the funds within the following are classed as undrawn funds if, immediately before the beneficiary's death, they were held within:

  • dependant's flexi-access drawdown fund,
  • dependant's drawdown pension fund (capped drawdown),
  • nominee's flexi-access drawdown fund,
  • successor's flexi-access drawdown fund,

A successors’ annuity is not the direct continuation of a joint or nominees’ annuity.

Section 167(1) Finance Act 2004 and Paragraph 27FA Schedule 28 Finance Act 2004

If any type of annuity is purchased then the money is leaving the pensions environment. 

Dependants’ / nominees’ /successors’ drawdown

Flexi–access drawdown for a beneficiary works in a similar way to flexi-access drawdown for a member but without the age restrictions in relation to access. Therefore, a child aged 5 years old may be receiving drawdown income. The beneficiary can take anything between 0% or 100% of the drawdown fund.

If a beneficiary chooses to move into drawdown then the money remains within the pension environment. This means that on the death of the beneficiary, the funds can pass onto their beneficiary (successor) and so on.

Dependants’ drawdown was available before 6 April 2015 but it was not possible for anyone apart from a dependant to benefit. If a dependant was in capped drawdown on 5 April 2015 then they can remain in capped drawdown but all the rules of capped drawdown will still apply. They can also choose to convert to flexi-access drawdown.

Note that this action does not invoke any Money Purchase Annual Allowance rules.


Paragraphs 22B to 22D Schedule 28 Finance Act 2004

If a dependant was in flexible drawdown immediately before 6 April 2015 then from that date it is automatically treated as a flexi-access drawdown fund.

If a dependant child first designated funds into drawdown (flexi-access or capped) before age 23 and then reached age 23 after the 16 September 2016, they can continue to receive dependant’s drawdown, regardless of the fact that they have passed age 23.

Paragraph 6 Schedule 5 Finance Act 2016

 

However, what can be paid out depends on who is going to receive it as the following diagrams explain.  

 

Death Benefits(1)

 

 

Death Benefits(2)

 

Death Benefits 3

 

Death Benefits (4)

 

It is essential that clients are aware of the way the law works.  If a member has a separated spouse and two adult children but dies without an expression of wish form filled in, then the provider will be restricted. Evidence could be received that they would not want the separated spouse to receive any benefit but would instead want their children to benefit. However, as the separated spouse is technically a dependant and the children are not, all the children could receive is a lump sum which may not be the most tax-efficient.

In addition, as mentioned above, although the law can allow full flexibility of death benefits this is conditional on the scheme rules allowing this and may not actually happen in practice. 

Occupational schemes

Occupational money purchase schemes often do not offer the full range of death benefits. They will usually provide lump sum death benefits (payable in addition to the value of the pension fund). The lump sum

  • may be calculated as a multiple of earnings (as for defined benefit schemes) or a fixed amount, and
  • may have been set at a level that allows scope to buy a dependant's pension (as well as paying some lump sum).
  • generally, is the value of the uncrystallised fund at the point of death. On death, the pension fund can be used to provide a lump sum death benefit and / or dependant's pension benefits, with the lump sum (up to the member's unused lifetime allowance) being the usual choice.

A member will get details of the death benefits in the pension scheme booklet, yearly statements, or by contacting their scheme trustees. An employer is required to provide pension provision to satisfy their auto-enrolment duties. If an employer doesn't provide an occupational type pension scheme for their employees they may provide group personal pension or group stakeholder plans. In addition they may provide separate death in service benefit cover, perhaps via a group life plan – more of this later.

Post-crystallisation, the death benefits provided will depend on how benefits were put into payment (crystallised) and the terms of the plan. The main options offered at crystallisation may include:

  • a scheme pension
  • a lifetime annuity
  • flexi-access drawdown (or in some cases capped drawdown).

The benefit offered at crystallisation depends on the type of scheme. DC schemes may offer a scheme pension (although this is unusual and more information on scheme pension can be found in our Death benefits for defined benefits article ), paid either by the scheme directly or via an insurance company selected by the scheme administrator. Before offering a scheme pension the member must be given the opportunity of selecting the option of a lifetime annuity. If the member wishes to access options not offered by their particular scheme, they would have to transfer to an alternative scheme.

Death benefits – group life schemes

Employees often have death in service cover as part of their contract of employment with typically '3-4 times their salary' as the benefit, but sometimes higher (to allow members' beneficiaries to use part of the lump sum to provide a dependant's / beneficiary's pension). Pensions legislation has a dramatic effect on the way in which death in service benefits are designed and delivered in the UK. Group life cover is a way of providing death benefit while a member is still employed by the company – usually paid as a lump sum. These benefits must be within limits set out in the scheme rules.

Although underwriting may be necessary, most large schemes which offer group life assurance have a free cover limit – strictly speaking, 'an automatic cover level'. This offers:

  • life cover without providing medical evidence. Therefore no underwriting is required below certain amounts. Usually the employee must join the scheme at their first opportunity and be actively at work (not off sick) at that point
  • life cover at standard rates below certain limits.

This is possible because the membership of group schemes would provide a large pool of people to spread the risk across. Exemptions from underwriting would also reduce administration costs.

The cost of life assurance premiums is usually decided on a 'single premium' basis. This means that the cover is valid for a year and is renewed each year. The premiums may also go up as the member gets older (as the average risk of dying increases).

Underwriting is the process by which the insurer decides to accept or decline applications for life cover (and health insurance and some annuities) on the basis of the medical history information provided.

Individual plans

The death benefits provided by individual plans such as retirement annuity contracts, personal pensions, stakeholder pensions etc. are different from those provided by an occupational scheme. However, they may still not offer the full flexibility described above.

Generally, the death benefit from individual pension plans is based on the value of the pension fund at the point of death (as opposed to being defined by the scheme rules). On death pre-crystallisation, the pension fund can be used to provide a lump sum death benefit and / or beneficiary income. Some older type plans, such as early retirement annuity contracts, build a deferred annuity rather than a fund of money at retirement. For these, the death benefit may be expressed differently (return of premiums, with or without interest, etc.) Alternatively, the "fund equivalent" of a deferred annuity may be calculated.

In the past, it was possible to link additional life cover directly to personal pensions (PPs, stakeholder and the group versions of these plans). This additional life cover was called pension term assurance and provided a lump sum over and above the value of the pension pot. However, in April 2007, HMRC withdrew tax relief on new pension term assurance. So if an individual pension holder's circumstances dictate a need for a lump sum on death, they should address this need outside their pension arrangements. If pension term assurance was linked to an individual pension before April 2007, this additional cover can continue (providing no material changes are made) and will provide an additional lump sum on death, depending on the terms and conditions of the policy.

The lifetime allowance

A payment made on the death of a member is made 'in respect' of that member. So any checks for lifetime allowance (LTA) purposes (if applicable) are against the member, not the recipient.

Death benefits, before age 75, from uncrystallised funds which are paid within two years, count towards the member's LTA irrespective of whether they are paid as a lump sum, annuity or drawdown. Prior to April 2015, pre-age-75 uncrystallised lump sum death benefits had been subject to an LTA test, but income benefits were not tested against the LTA – this is no longer the case, except for provision of a dependant’s scheme pension, which as covered previously, is unusual from defined contribution pension funds.

If the benefits are over the standard or protected LTA there is no longer scope for the excess to be used for a dependant's income, to minimise any LTA charge. On death before 75, uncrystallised funds distributed within two years and in excess of the LTA, will be liable to the respective LTA, which cannot be avoided by the method of distribution.

However, if payments of the benefits are paid out with the two years or the funds have crystallised, the LTA test will no longer apply, but the benefits will be taxable.

Paying the lifetime allowance charge

Death benefits can be paid to more than one beneficiary. But, even if the benefit is split to a number of beneficiaries, the total death benefit to all the beneficiaries still needs to be checked against the LTA.

HMRC guidance states that the reason for treating the BCEs as occurring simultaneously is to ensure that where more than one relevant post-death BCE occurs following the member's death, any arising lifetime allowance charge liability is allocated fairly where there are two or more recipients. This is an issue where the member has some available lifetime allowance left at the point of death.

Where those benefits were paid to, or funds were designated for flexi-access drawdown for more than one recipient, the lifetime allowance charge liability of each recipient is apportioned by HMRC on a 'just and reasonable' basis. In practice this will mean the amount is apportioned pro-rata between recipients according to the amount received by each, so that each recipient is liable for only a proportionate share of the total amount of tax payable. The recipients are not jointly and severally liable for the entire amount of tax.

Let's demonstrate how this should work in practice.

Example

Client has £200,000 remaining lifetime allowance before they die under age 75
Death benefits paid are;
Lump sum death benefit of £100,000 (paid to beneficiary A)
Dependant’s drawdown of £100,000 (paid to beneficiary A)
Nominee drawdown of £100,000 (paid to beneficiary B)
Dependant annuity of £100,000 (paid to beneficiary C)

Firstly, we need to identify the tax liability. As all BCEs are treated as having happened simultaneously, the tax charge would be calculated by:

Total value of death benefit BCEs £400,000
(25% paid as lump sum, 75% paid to provide beneficiary income)

Lifetime allowance excess is £200,000
(and it follows that 25% of this amount is subject to a 55% tax charge, and 75% subject to the 25% tax charge)

25% of the LTA excess paid as lump sum, tax charge due is 55% of £50,000 = £27,500
75% of the LTA excess paid as income, tax charge due is 25% of £150,000 = £37,500
Total charge £65,000

Next we consider who is liable for paying the tax charge:

Where there are multiple beneficiaries the lump sum tax would be a pro rata amount across lump sum recipients and the income tax across income recipients.

Beneficiary A, as the only recipient of any lump sum death benefit in our scenario, is liable for the full amount of tax charge in respect of the lump sum payment plus one-third of the tax charge in respect of the beneficiary income payment. Beneficiaries B and C are each liable for one-third of the tax charge in respect of the beneficiary income payment.

Beneficiary A will have to pay £27,500 + £12,500 = £40,000
Beneficiary B will have to pay £12,500
Beneficiary C will have to pay £12,500
Total charge £65,000

Pensions Tax Manual - PTM087000

Taxation

The taxation of death benefits changed dramatically through the Taxation of Pensions Act 2014 as part of the Freedom & Choice pension reforms.

 

Drawdown Funds (post-crystallisation - flexi-access drawdown funds)

Unvested funds (uncrystallised funds)

Death before 75

Tax-free to beneficiary, as a lump sum or as a series of withdrawals (No further LTA test as LTA was tested at crystallisation**)

Tax-free to any beneficiary as a lump sum or income (up to the value of the LTA ***)

Death after 75

Any beneficiary can draw an income or lump sum from the fund, taxed at their marginal rate. No further LTA test*

Beneficiary can draw an income or lump sum from the fund at their marginal rate. No further LTA test*

* Payments to "non individuals" eg a trust will have a 45% lump sum charge deducted from the funds.

** Payment of a lump sum must take place within two-year period or benefits will be subject to income tax.

*** Benefits paid within the two-year period are tested against the LTA and income tax-free. After two years, there is no LTA test but the benefits are subject to income tax.

Defined contributions pension death benefits

Age at death

Paid from

Benefit Type

Relevant time

Tax

Subject to LTA?

< 75 years

Crystallised

Income / lump sum

< 2 years

Tax Free

No

< 75 years

Crystallised

Income

> 2 years

Tax Free

No

< 75 years

Crystallised

Lump sum

> 2 years

Marginal

No

< 75 years

Uncrystallised

Income / lump sum

< 2 years

Tax Free

Yes

< 75 years

Uncrystallised

Income / lump sum

> 2 years

Marginal

No

=> 75 years

Crystallised

Income / lump sum

< 2 years

Marginal

No

=> 75 years

Crystallised

Income / lump sum

> 2 years

Marginal

No

=> 75 years

Uncrystallised

Income / lump sum

< 2 years

Marginal

No

=> 75 years

Uncrystallised

Income / lump sum

> 2 years

Marginal

No

Charity lump sum death benefit

A charity lump sum death benefit is, as it suggests, a lump sum paid to a charity on the member or beneficiary’s death. A member may express a wish for a charity to receive some of their death benefits but in addition a lump sum death benefit may also be left to a registered charity free of tax provided:

a) no dependants of the original member are alive
b) the member or if the member hasn't nominated, the dependant / nominee / successor nominated the charity.

The charity must be one that is registered with the Charity Commission for England & Wales (www.charitycommission.gov.uk) or their Scottish (OSCR) or Northern Ireland counter-parts and they must use the payment for charitable purposes.

The conditions for payment are:

Death of a member

  • sum is paid on the death of the member

  • there must be no dependants of the member

  • sum is paid in respect of drawdown pension funds
  • sum is paid to a charity nominated by the member

or

  • for payments before 16 September 2016 the member died having reached age 75 (for payments on or after that date there is no restriction on the age of the member),

  • there are no dependants of the member

  • the member had relevant uncrystallised funds under a money purchase arrangement when they died, and

  • the sum is paid to a charity nominated by the member.

Paragraph 15(2B) Schedule 28 and paragraph 18 Schedule 29 Finance Act 2004

Death of a beneficiary

A lump sum is a charity lump sum death benefit if the following conditions are met:

  • sum is paid on the death of a beneficiary
  • there are no dependants of the member at the time of the payment
  • sum is paid in respect of either:
    • a dependant’s drawdown pension fund at the date of the dependant’s death in respect of an arrangement relating to the member, or
    • a nominee’s / successor’s flexi-access drawdown fund at the date of their death in respect of an arrangement relating to them as a nominee/successor
  • sum is paid to a charity nominated by the member or if the member made no nomination by the deceased beneficiary.

The maximum amount of charity lump sum death benefit must be no more than the value of the arrangement at the time of the payment.

A charity lump sum death benefit is paid tax-free. However if not used for charitable purposes the payment is treated as an unauthorised payment. Payment of a charity lump sum death benefit is not a benefit crystallisation event. The two-year rule for payment of death benefits will not apply if it is paid to a charity. 

Nominations

The member can nominate the charity to which the payment is made.

The member can make a number of nominations depending on the circumstances that exist at the time of their death. If there is a dependant alive at the time of the member's death, the remaining funds must be used to provide that dependant with a pension death benefit, but the member can still nominate in advance what happens to any remaining funds if that dependant then dies. Where the member does not nominate, or the member's nomination becomes void (eg the charity ceases to exist) the dependant can nominate, but the dependant cannot override a member's nomination.

The scheme administrator cannot choose the charity receiving the payment.

Para18, schedule 29, Finance Act 2004

Winding-up lump sum death benefit

This payment type was removed 6 April 2015.

Pensions Tax Manual - PTM073800

GMP (MP scheme with GMP underpin)

The GMP would have been paid to the member as a pension at vesting and as such would not form part of the drawdown pension fund. If the member dies with a surviving spouse / civil partner, a spouse's GMP would become payable, which could, potentially, be commuted for a trivial commutation LSDB. If the member dies with no surviving spouse, then there is no requirement to continue paying a GMP.

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