If death occurs before age 75, an important point to note is that there is a major difference between the tax treatment depending on whether death benefits are paid as income or a lump sum.
Anything paid as a lump sum above the available LSDBA will be taxed at the beneficiary’s marginal rates of income tax, however income would not be taxable.
Example
Sarah is 67 and has a pension pot of £1,300,000 in May 2024, she takes £150,000 of tax-free cash and moves £450,000 into drawdown.
She has £850,000 of uncrystallised funds remaining, and unfortunately passes away in December 2024.
As she died aged under 75, the maximum tax-free lump sum payment that could be paid would be £923,100 (£1,073,100 - £150,000).
This leaves an excess of £376,900 (£1,300,000 - £923,100).
If the excess of £376,900 is paid as a lump sum, it is subject to the beneficiary’s marginal rates of income tax.
If it is paid as income, ie drawdown or as an annuity, no tax charge will apply.
It is important to note that in this example, the lump sum payments on death from drawdown funds are included in the LSDBA whereas previously, under the LTA rules, they were not tested on death.
Impact on retirement planning
Where clients have benefits that exceed the LSDBA, they should ensure that the option of paying death benefits as beneficiary’s drawdown is available wherever possible.
This will mean that, on death under the age of 75, all benefits could continue to be paid free of tax regardless of the value.
This means it is important to check nomination forms to ensure this allows for income to be paid to potential beneficiaries as well as named beneficiaries.
Those with existing LTA protections will have both higher tax-free cash limits and higher lump sum and lump sum death benefit limits than those detailed above.
The tax-free element of any UFPLS will reduce both the LSA and the LSDBA.
However, payments made under the trivial commutation, small pots or winding-up lump sum rules will not count towards the lump sum limits.
Where death occurs aged 75 or over, all benefits become taxable at the beneficiary’s marginal rates of income tax in the same way as currently.
Age 75 tests
The age 75 tests on funds in drawdown and any uncrystallised funds will no longer apply. This is because no lump sums are paid out of the scheme and so there is nothing to test.
Any tax-free cash taken age 75 or over will be subject to the LSA in the normal way, along with the tax-free element of any UFPLS payments.
