What happens to your private pension when you die?

No-one likes to think about what happens after they die, but there is some planning you cannot afford to avoid.

This is especially true when it comes to your pension.

After all, you’ve spent all your life working hard to amass that money, so you want to ensure your wealth is used exactly how you would like.

For most private pension schemes, your remaining pot can be passed on to your beneficiaries.

Here we take a closer look at what happens to your retirement fund when you die.

Does the type of private pension impact what happens to it?

When you pass away, what happens to your private pension depends largely on the type of scheme you are part of – and the rules that govern it.

In a “defined contribution” pension (sometimes called a “money purchase scheme”), you build up a “pot” with your contributions, and those from your employer, which is then invested for you. 

The size of that pot when you retire determines the level of income you can get.

Sue Loveridge, financial planner at Quilter, said: “If you die before drawing this pension, the whole pot can usually be passed on to your beneficiaries.”

While a defined contribution scheme doesn’t have to be linked to an employment, it often is.

Tom Selby, the head of retirement policy at AJ Bell, said: “If you have a defined contribution pension, such as a SIPP (self-invested personal pension), you can nominate as many people as you like to inherit your retirement pot, or portion of your pot.”

What is a beneficiary?

A beneficiary is the person or people who will receive your pension funds when you die.

Ms Loveridge said: “This can be anyone you want, though is typically, a spouse, children, or other dependents.”

Exactly who benefits tends to be dictated by what is known as an “expression of wishes”.

Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “This form allows you to name who you would like to receive death benefits. Administrators and trustees will refer to them when dealing with your pension.”

It’s crucial to keep your expression of wishes forms updated to ensure your plans are carried out.

Ms Morrissey added: “If these are not kept updated, there is a risk your benefits could, for example, get paid out to an ex-partner, rather than your current one. This can cause huge financial pressures.”

It’s vital to revisit these forms following key life events, such as marriage and divorce, to make sure the right person benefits.

How will my beneficiary receive my private pension?

The beneficiaries of a defined contribution private pension have a few different options:

• Lump sum payment – this enables beneficiaries to receive the entire value of your pension in a single, lump sum. This might be suitable if they have a large, immediate financial need.
• Lifetime annuity – with this option, the beneficiary can use the pension pot to buy an annuity. This gives them a regular income, just like a salary, which they can receive for the rest of their life.
• Beneficiary drawdown – with this flexible option, the beneficiary can leave the pension pot invested and take out amounts as and when needed. This allows them to control the amount and frequency of payments.

How will inheritance tax affect my private pension?

In most cases, your private pension (defined contribution), is outside of your estate for inheritance tax (IHT) purposes. 

This means it’s typically free from the levy. This does not mean inherited defined contribution pensions will always be completely tax-free, however.

Mr Selby added: “The tax treatment depends on how old you are when you die, and whether your beneficiaries take the money as an income or a lump sum – and this is where it gets a bit complicated.”

Typically, if you die before 75, beneficiaries can take out money from your pension free of income tax.

Mr Selby said: “Equally, where a pension has already been accessed or ‘crystallised,’ and is inherited as a lump sum, there will be no tax to pay. 

“However, any inherited pension that has not yet been accessed (‘uncrystallised.’), and is taken as a lump sum will be checked against the lifetime allowance.”

For most people, this is £1,073,100. If you have used up your lifetime allowance, income tax will be charged on the excess.

The current rules may be at risk of changing, however: the Government has confirmed it is consulting on whether to apply income tax to these pensions if they are taken as income.

Mr Selby said: “We could see even more complexity added by creating a new pension ‘death tax’ where someone dies before age 75.”

If you die after the age of 75, things are a bit simpler. Any withdrawals your beneficiary makes from the pension pot will be subject to their marginal rate of income tax.

Mr Selby said: “Income tax will simply be applied to the entire pension, whether it’s inherited as a lump sum or as income. Of course, by taking any inherited pension as income, via dependent’s drawdown, your beneficiary can minimise their income tax bill by drip-feeding withdrawals.”

Seek advice and professional help

Be aware that pensions can be complicated at the best of times, particularly when it comes to passing the pot on to others.

Ms Morrissey said: “It’s important to consider the tax position when deciding how to access a pension. For example, opting for a large lump sum can potentially tip the beneficiary into a higher tax bracket. You need to tread with care.”

It’s always worth seeking professional advice to ensure your pension wealth is passed on in line with your wishes.

What about defined benefit pensions?

The rules are different for this type of scheme, also known as “final salary schemes”, where the pension is based on your salary and how long you’ve worked for your employer.

But note that these are not private pensions. A defined benefit scheme is always linked to an employment and are most commonly found within the public sector. While there are still a few within the private sector, these are very rare.

Ms Loveridge said: “With a defined benefit scheme, a beneficiary would get a death-in-service payment if you die before retirement. But if you die after you have retired and started drawing your pension, the spouse would just get a spouse’s pension.”

That said, some schemes will also pay a small lump sum for a few years after retirement. This will depend on the scheme.

Ms Morrissey added: “If you have children, they may also receive a pension. This will depend on whether they are still in full-time education. It’s worth checking the rules of your particular scheme.”

Often, defined benefit pensions come with generous inflation protection which will also be applied to any inherited pots.

Mr Selby said: “While inherited defined benefit pensions will count towards income for income-tax purposes, be aware they will not count towards your estate for inheritance tax purposes.”

Once again, if there’s anything you’re unsure about, the best move is to seek professional advice.