Pensions – Ensure your family doesn’t face unnecessary taxes and stress

When you pass away, it is important that your assets go to the people you wish to inherit them and that they receive the maximum benefit from what you leave behind.

Pensions are a significant part of this process as they are not normally considered part of your estate, which means they aren’t usually liable for Inheritance Tax (IHT). So, it is a good idea to formally allocate your pension beneficiaries, as inheriting a pension can often be more tax-efficient than other assets.

However, without the right planning, your beneficiaries could end up paying more tax on the pension you leave behind than necessary.

If you pass your pension on outside the pension wrapper, your beneficiaries could face paying up to 45% in Income Tax on the fund, or 40% in IHT. Yet, if the funds remain within the pension, they may be able to withdraw it tax-free or at a lower rate.

Read on to learn what happens to different types of pensions when you pass away, and how to ensure your beneficiaries avoid overpaying taxes on the pension you leave behind.

There are 3 different types of pensions in the UK

In the UK, there are three types of pensions you can invest in:

• Defined contribution (DC) pensions – A pension based on contributions made by you, your employer, or both, and any investment growth.

• Defined benefit (DB) pensions – A pension that is usually arranged by your workplace, based on factors such as your salary or how long you worked for your employer.

• State Pension – A pension provided by the state based on how much National Insurance contributions (NICs) you made.

What happens to each type of pension after you die, depends on when you die, who you leave them to, and when you start drawing from them.

It is important to nominate a pension beneficiary and keep it updated

Nominating a pension beneficiary is a formal way of notifying your provider who you want them to pay your pension to in the event of your death. Your pension provider may ask you to complete an expression of wishes form laying out who your beneficiaries are.

You can add or update the number of beneficiaries at any time, and it is important to do so.

If, for example, your original pension beneficiary dies or you separate from them, you will need to formally name another. If you don’t, your provider will either give part of your remaining pension to the original beneficiary or decide who inherits it on your behalf.

If you have more than one beneficiary, you can also specify how you want your pension to be split.

For example, if you have two beneficiaries, you may want one person to receive a quarter of your pension and the other to get three-quarters.

You might consider updating your pension beneficiaries after any significant life event, such as the birth of a child or grandchild, a marriage, a divorce, or the death of a loved one.

Allocating beneficiaries is crucial for ensuring your pension goes to who you want it to go to, but it can also improve the tax efficiency of your legacy. By carefully designating beneficiaries, you can optimise the tax benefits of your pension and minimise potential liabilities.

A financial planner can help you in each step of this process.

At MLP Wealth, we can assist you in allocating your pension or one you have inherited to ensure the pension remains tax efficient and you or your beneficiaries are best supported by the money.

Just recently, we guided a bereaved family through the process of transferring pensions in a tax-efficient manner, alleviating much of the financial stress during an emotionally challenging time.

How your pension is taxed after your death depends on the type of pension it is and when you die

HMRC does not normally consider your pension as part of your estate, so it is not usually liable for IHT.

However, if the money is withdrawn from the pension wrapper – such as when you or your beneficiaries draw a lump sum – it may be liable for IHT, or your beneficiaries may pay a higher Income Tax rate on the funds.

For example, if one of your beneficiaries withdraws a lump sum from the pension, it could push them into a higher Income tax bracket, resulting in a significant tax bill. So, instead of benefiting from the pension's tax-free status, they may face up to 45% in Income Tax on the amount withdrawn, depending on their other income.

Alternatively, if you withdraw a lump sum from your pension before passing away, the money may fall outside the pension wrapper and could be subject to 40% IHT.

So, it is a good idea to plan carefully and ensure the funds remain within the pension wrapper, preserving tax efficiency and minimising potential tax liabilities.

Defined contribution pensions

The taxes levied on inherited DC pensions are based on your age at death and whether you already started drawing from it.

If you pass away before the age of 75 and have not accessed your pension, your beneficiary will receive the pension tax-free, up to the lump sum and death benefit allowance (LSDBA) of £1,073,100 for the 2024/25 tax year.

If you’ve already taken any tax-free cash payments from your pension, the limit is reduced.

Any payments over the LSDBA are normally taxed at the beneficiary’s marginal rate of Income Tax.

If you die after the age of 75, your beneficiary will pay Income Tax at their marginal rate on any pension you leave behind.

Defined benefit pensions

If you leave a DB pension, the amount your beneficiary will receive is determined by the rules of the pension scheme.

Generally, if you die before your retirement, your beneficiary will typically receive a lump sum based on a multiple of your salary. This lump sum is normally tax-free if you die before the age of 75.

If you pass away after retiring, a defined benefit (DB) pension will typically continue to provide a reduced payment to your beneficiary or dependants. However, the definition of a dependant can vary between pension schemes.

State Pension

If you reached the State Pension Age after April 2016 and received the new State Pension or were going to receive it, your spouse or civil partner may be able to inherit part of it.

It will be considered part of their income and they will pay tax on it at their marginal rate.

A financial planner can help ensure your pension remains tax-efficient when you die

A financial planner can provide valuable guidance to ensure your pension remains tax-efficient when you pass away. By helping you navigate complex tax rules and carefully allocate beneficiaries, they can preserve more of your pension wealth for your loved ones.

To speak to a financial planner, get in touch.

Email info@mlpwealth.co.uk or call us on 020 8296 1799.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.

Workplace pensions are regulated by The Pension Regulator.