Right pension, right nomination, right now!

IHT isn’t the only tax to think about – there’s also income tax to consider. Beneficiaries will be subject to income tax on any benefit they receive if the client dies over the age of 75. If a client dies before age 75, beneficiaries may be subject to income tax only if they take their benefits as a lump sum which is more than their remaining lump sum and death benefit allowance (LSDBA). 

Helping a client’s loved ones to navigate the options available to them, and structure their benefits in the most tax efficient way, can lead to a lasting client relationship. But this starts with ensuring clients are in the right pension with the right nomination in place so that death benefits can be paid flexibly.

The right pension

The trustees or scheme administrators of a money purchase pension will typically have discretion over the payment of death benefits.

The chosen beneficiary will potentially have the choice of a lump sum or a pension (via income drawdown or annuity). However, those options may be limited by what the scheme will allow - for example, not all schemes can facilitate income drawdown. 

If the only option is a lump sum, the whole amount inherited could be taxed in a single tax year, potentially exposing a large portion of the inheritance to income tax at 45% in addition to any IHT. 

Inherited drawdown on the other hand means income tax is only applied when withdrawals are taken. This allows any income withdrawals to be spread across many years allowing income to be managed within available allowances and tax bands to minimise the overall tax liability.

There is typically no income tax on pension benefits where death occurs before age 75. However, lump sums will be tested against the deceased’s LSDBA and any excess will be subject to income tax on the beneficiary. Where a beneficiary opts for inherited drawdown rather than a lump sum this is not tested against the LSDBA as it is deemed to be income even though the beneficiary remains able to withdraw the whole amount in one go.

Getting the nominations right

Even where a client is in a scheme which offers all the retirement and death benefit options, this doesn’t mean that all beneficiaries will automatically have all the options available to them.

Dependants will have the choice of a lump sum or a pension income. But that may not be the case for non-dependants, such as the deceased’s adult children.  If a parent hadn’t nominated their adult children, their only option may be a lump sum. This is because, if the deceased parent:

• had nominated another individual (or a trust or charity) or
• has a dependant,

then the trustees or scheme administrators cannot allow anyone else to use the funds for pension purposes i.e. drawdown or annuity.

So, if a non-dependant is to potentially benefit, it’s crucial that they’re nominated to avoid what could be a large income tax bill on a one-off lump sum, particularly if the member should die after their 75th birthday. 

Make sure the client’s wishes are clear

It's critical that client’s wishes are identified and detailed clearly, to avoid misinterpretation.

Leaving everything to the spouse avoids IHT on the death benefit. This may appear to be the easy option and difficult decisions on who should benefit can often get kicked down the road. But the death benefits may provide more than the spouse wants or needs. This could simply delay the inevitable IHT charge and potentially impact the availability of the spouse’s residence nil rate band if their estate now exceeds £2 million. It could also limit the options available should their spouse predecease them.

Even where the client’s intention is to leave everything to their spouse, it can still make sense to name other beneficiaries who would then also have all the lump sum or income options should the spouse not require all of the benefits.

Reviewing nominations

Nominations can normally be changed at any time - for example, a change in family circumstances - and should be regularly reviewed to ensure that they continue to be in line with the member’s wishes and the needs of their beneficiaries, whilst providing tax efficiency.

The change in the taxation of death benefits from age 75 should be an obvious prompt to review nominations. Death benefits will no longer be paid tax free once the member has reached their 75th birthday.

With the Aberdeen SIPP a fresh nomination can be completed on the platform, so it makes sense to incorporate this into the client’s annual review to ensure client’s wishes are always fully up to date. 

Right now?

It's important to check that the death benefit options on offer on your client’s existing pensions match their expectations. Action may need to be taken before it's too late.

It’s easy to think that these decisions can be left until another time. But an untimely death or the diagnosis of a serious illness can mean that a client’s wishes cannot be followed.

The value of investments can go down as well as up and your clients could get back less than they paid in.

The views expressed in this article should not be regarded as financial advice.

Any reference to legislation and tax is based on Aberdeen's understanding of United Kingdom law and HM Revenue & Customs practice at the date of production. These may be subject to change in the future.