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Pensions and inheritance: what happens to your pension when you die?

Here we look at what happens to leftover pension money when you die. This is important because an understanding of this issue could mean you change the way you use your different pots of savings during retirement in order to deliver better tax outcomes for your family or other heirs.

The difference between your pension pot and a pension income

First, let’s have a quick reminder of an important distinction. When people talk about a pension, they are often referring to a regular retirement income, such as that paid by an annuity or the state pension. A quite different concept is your pension pot: money stored in a pension account in the form of cash, shares or other investments.

When you die these different forms of pension work very differently.

Regular income from an annuity or final salary pension might continue to be paid to your spouse or partner after your death. They might receive all the income or (much more commonly) they might receive half or two-thirds of the former monthly sum. This depends entirely on the type of annuity you entered into or the terms stipulated in your final salary pension.

If and when you plan ahead for the eventuality of your death, you need to note what your surviving spouse can expect to receive from these arrangements. This has always been the case.

By contrast, the issue of bequeathing a pension pot is somewhat new. It is also likely to become far more common as more people choose to manage their pension cash into retirement along the lines laid out on this website.

Inheritance tax and your pension pot

One of the most significant elements of George Osborne’s changes to the pension regime was to scrap the death tax that applied to pension assets. There was never inheritance tax to pay for those inheriting a pension pot, but Osborne’s reforms saw the end of a separate tax on pensions that had the same effect.

This provides a huge benefit to the better-off. It’s also a great incentive to leave pension assets intact within the pension pot – rather than turn them into an income by, for instance, purchasing an annuity.

Inheritance tax is relatively simple. Each person has an exemption, or ‘nil-rate band’, of £325,000, which they can leave to their beneficiaries free of tax. Married couples and civil partners can add their exemptions together and leave a combined £650,000 tax-free. (There is also a further allowance that applies to the family home which is currently being phased in by the government.) Above those thresholds, an estate is taxed at 40%.

Pension pots enjoy unique tax treatment, different from a family home or your other savings and investments. Because of this, there are tax implications relating to the order in which you spend or give away your various assets.

Take this scenario outlined by one fortunate saver:

Q: I am a widow managing to get by on my state pension and a small company pension paid to me following my husband’s death. My husband also left £330,000 in a pension account managed by his stockbroker. I have £200,000 in ISAs. I am not sure what to do with these. I live in an expensive part of Surrey and estimate my house to be worth at least £1m, so I am worried about inheritance tax and want to leave as much as possible to my two daughters. I am 82.

A: The value of her property means this woman’s estate is going to be liable to some inheritance tax whatever she does. But she could certainly take steps to limit the potential tax due on the other assets, thanks to the pension pot being free of any inheritance tax liability.

Because she can bequeath the full £330,000 pension pot to her children free of inheritance tax at her death, she should keep that money intact. It can remain invested relatively “aggressively” – largely in shares, for example, as opposed to cash – depending on the age of her daughters and their own needs for the money.

Let’s assume she’s taken on her husband’s £325,000 nil-rate band allowance, which in addition to her own gives £650,000. There should also be a further exemption that applies to her home (the exact value of this extra allowance will depend on the year of her death, as it is being phased in). But for now let’s assume that of her total £1.2m non-pension assets (house at £1m and £200,000 in ISAs), the value above the combined nil-rate bands of £650,000 will be taxed at 40%. The £200,000 ISA savings will therefore be liable to a 40% tax charge.

If she needs to spend money on herself, supplementing her income or paying for care, for instance, she should use this ISA cash before touching the pension. Alternatively, if she has no need for the £200,000 ISA money, she could immediately give it to her two daughters, taking advantage of what is known as the ‘seven-year rule’.

This rule allows assets to fall outside the estate for inheritance tax purposes provided that the giver (or what the taxman calls the ‘donor’) survives for seven years after making the gift. If she used the money in her pension instead she would forfeit the ability to leave it to her children free of inheritance tax after her death.

She would also have to withdraw the money from the pension before she gave it to her daughters, and this would incur a tax charge.

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As you can see, there is an incentive for those people whose overall assets exceed the nil-rate band to use their pension savings as a last resort, and to spend other savings first, in order to leave more tax-free inheritance for their heirs.

Taking this argument to its extreme, some financial planners might even suggest that the woman above – or others in similar situations – consider borrowing money against their home. Doing so reduces the value of the property for inheritance tax purposes and frees up cash which could be given to beneficiaries right away or spent, for instance, on the woman’s care in later life. The pension then becomes the biggest single asset, which is able to be passed on free of tax.

There are a number of risks to borrowing later in life, however, and you should always seek professional advice before undertaking such a strategy. These risks are looked at in more detail in our article on equity release.

Thinking ahead about what will happen to your pension after your death

As a starting point, nominate who you wish to inherit your pension, by formally lodging that information with your pension provider.

Just because your pension pot isn’t taxed in the same way as the rest of your estate, it doesn’t follow that your heirs can get their hands on it entirely tax-free. In general, this is how the recipients of your pension pot will be taxed:

• If you die before age 75 and leave a pension pot, the recipients of your pension pot will be able to take the money tax-free.

• If you die at age 75 or over and leave a pension pot, the recipients will be taxed on withdrawals from that pension at their own rate of income tax. They do not have to be over age 55 to make withdrawals.

Just as you would want to manage your pension withdrawals to minimise income tax (see our page What you need to know about tax on pensions), so your spouse, children or other beneficiaries might need to do the same when it comes to accessing the pension pot you leave them. The rules also allow pots to be passed on more than once.

Say you die, and your wife or husband takes ownership of your pot. Any of the money that is unspent in the remainder of their life can remain within the pension and can pass on again to your children or other beneficiaries.

Cashing in your final salary pension benefits in order to bequeath them

Final salary pensions are extremely valuable, as we explain elsewhere. In most cases you would not want to encash these entitlements.

If you have reached retirement age and started to take the final salary pension income you are not likely to have any choice in the matter in any case. But if you have yet to start taking income from a final salary scheme you may be able to take cash instead. The amount you would get is called the ‘transfer value’.

The final salary pension administrator will undertake a calculation to place a lump sum value on the lifetime income you would receive if you were to draw your final salary pension as an income in the normal way. It will then produce the transfer value figure, which is the cash payment the administrator will offer you to leave the scheme and give up the promised pension income. This is a complex process.

When the transfer value is presented to you, if it is £30,000 or more then you are required to take financial advice by law. This is because the authorities want to ensure that anyone who takes this irreversible step is fully aware of the risks.

But there may be circumstances in which the lump sum is far more valuable. Here is a real-life scenario:

Jonathan, in his early fifties, was in generally poor health and not working. He would have to wait until his pension scheme retirement age of 62 before he could take a final salary pension built up in his former employment. This would pay an income of around £12,000 a year, linked to inflation. Or he could take a cash transfer of £326,000 now.

His poor health was part of the reason to opt for the cash, as reduced life expectancy reduces the value of an income that lasts as long as you live. But he also had other investments that produced an income in the form of two properties.

His younger partner, to whom he was not married, was also able to support him financially. This meant his need for future income from this pension was relatively low. The value of the cash lump sum, however, especially as it could be bequeathed to his partner without inheritance tax, was more significant.

He chose to go ahead with the transfer. The money went into a pension pot where it was invested in a range of funds. If he needs to, Jonathan can access this money once he is 55. Otherwise it can remain invested.