Tax treatment of DC pensions on death

A defined contribution (DC) pension arrangement (also known as money purchase) is one where an individual makes contributions to a pension pot, which is invested, and which can then be used to provide an income at retirement.

The tax treatment of pension payments is provided for in the Finance Act 2004. This provides for payments classed as ‘unauthorised’ to attract significant tax charges.

Reforms in April 2015 (the ‘pension freedoms’) gave people aged 55 and over more flexibility about when and how to draw their DC pension savings, subject to their marginal rate of income tax. Previously, most people effectively had to buy an annuity because, except in limited circumstances, lump sum payments would attract an 'unauthorised payments charge'. The Coalition Government changed the rules to allow people aged 55 or over with DC pension savings to put them in a drawdown arrangement (from which they could make flexible withdrawals) or withdraw cash lump sums, subject to their marginal rate of income tax.

As part of the pension freedoms, it introduced more flexibility in the payments that could be made on death.

Whereas previously, a DC scheme member had to leave unused funds to a ‘dependant’ (a surviving spouse/civil partner or child under age 23), from April 2015, they would be able to nominate a beneficiary to receive their funds.

There were also reductions in the tax charges that could apply. Before April 2015, although the funds could be inherited tax-free if the individual died under age 75 and had not touched their pension savings, a 55% tax charged applied to lump sum payments from funds in drawdown (regardless of the individual’s age) or if the individual was aged 75 or over at death.

The Government thought a 55% tax charge on lump sums payments would be too high in a context where drawdown was a more widely available option. It changed the rules so that, from April 2015:

• If the scheme member died under age 75, payments to the beneficiary would be tax-free, if they were from a drawdown account, uncrystallised funds, or from an annuity set up after April 2015;
• If the scheme member died aged 75 or over, payments would be subject to the beneficiary’s marginal rate of income tax. (Cm 8834, para 1.159;HM Treasury press release, Sept 2014).

For an overview of these complex rules – see Gov.UK Tax on a private pension you inherit. Individuals considering their pension options can seek guidance from Pension Wise – the service set up to help people aged 50 and over with DC pensions understand the wider range of options available from April 2015. They may also wish to seek financial advice.

This note looks at the changes to the rules on the tax treatment of DC pensions on death from April 2015. The wider context for this – the pension freedom reforms - are discussed in Library Note CBP 6891