Pension Death Benefits: What Happens to Your Pension When You Die?

For many people, a pension represents one of the most significant assets they will accumulate during their lifetime. Yet its treatment on death -- who receives it, how, and what tax is payable -- is often poorly understood. With important changes on the horizon, it is worth taking stock of where the rules currently stand and what is set to change from April 2027.

The Current Position: Income Tax and the Age 75 Threshold

Under current rules, the tax treatment of pension death benefits depends primarily on whether the pension holder dies before or after the age of 75.

If death occurs before age 75, beneficiaries -- which can include dependants, nominees, or successors -- can generally receive the pension funds free of income tax. They may take the money as a lump sum or draw it down as income, in both cases without any income tax liability, provided the pension scheme is notified and the funds are designated within two years of the death.

If death occurs at age 75 or older, the position changes. Beneficiaries can still receive the funds, but any withdrawals will be taxed at their own marginal rate of income tax -- meaning the rate they pay on their next pound of income. For higher earners, that could be 40% or more.

The Two-Year Rule

Where death occurs before age 75, the income tax exemption is conditional. The pension scheme must be notified of the death, and the funds must be designated to a beneficiary -- either paid out or moved into a drawdown account -- within two years of the scheme becoming aware of the death.

If that two-year window is missed, the income tax exemption is lost and the funds become taxable at the recipient's marginal rate. It is therefore important that family members notify the pension scheme promptly after a death.

Defined Contribution Versus Defined Benefit Schemes

The tax-free treatment described above applies primarily to defined contribution (money purchase) pensions, which are the most common type for private sector employees and the self-employed. These are schemes where the pension pot grows based on contributions made and investment returns.

Defined benefit (final salary) schemes work differently. A dependant's scheme pension from a defined benefit arrangement is generally subject to income tax regardless of the age at which the scheme member died. Similarly, death in service benefits from a defined benefit scheme have their own rules and are not automatically covered by the under-75 income tax exemption.

The Lump Sum and Death Benefit Allowance

Where a tax-free lump sum is paid to beneficiaries, the total amount that can be received free of income tax is capped by the deceased's available Lump Sum and Death Benefit Allowance (LSDBA), currently set at £1,073,100. Any amount above that limit will be taxed at the recipient's marginal rate. This is a consideration primarily for those with larger pension pots, but it is worth being aware of.

The Importance of Nomination Forms

Pension death benefits do not generally pass under the terms of a will. Instead, they are paid at the discretion of the pension scheme trustees, who take into account any expression of wishes (also known as a nomination form) submitted by the member.

It is important that pension holders keep their nomination forms up to date with their pension provider, particularly after major life events such as marriage, divorce, or the birth of children. An out-of-date nomination -- or no nomination at all -- can lead to lengthy delays and, in some cases, unintended outcomes.

A Significant Change: Inheritance Tax from April 2027

The most significant development in this area is a change announced at the Autumn Budget 2024: from 6 April 2027, most unused pension funds and pension death benefits will be brought into scope of inheritance tax (IHT).

At present, pension funds held at death are generally excluded from the estate for IHT purposes, which has made pensions an attractive vehicle for passing wealth to the next generation. That is set to change. From April 2027, the value of an unused pension pot will count as part of the deceased's estate, alongside property, savings, and other assets, when calculating whether IHT is due.

The government estimates that around 10,500 estates a year will face an IHT liability where previously they would not, and approximately 38,500 estates will pay more IHT than at present.

A few important points to note about the new rules:

• The spousal and civil partner exemption is preserved. Pension assets passing to a surviving spouse or civil partner will remain free of IHT, as will assets passing to a registered charity.
• Death in service benefits from a registered pension scheme are excluded from the new rules and will remain outside the scope of IHT.
• Personal representatives -- rather than pension scheme administrators -- will be responsible for reporting and paying any IHT due on pension assets. This places additional obligations on those administering estates.
• Where death occurs after age 75, there is a risk of double taxation: pension assets could be subject to both IHT on death and income tax when the beneficiary draws the funds down.

What This Means in Practice

The April 2027 changes represent a fundamental shift in the way pensions should be considered as part of estate planning. For many people, particularly those with sizeable pension pots alongside other assets, the combined value of their estate may now exceed IHT thresholds in a way that it would not have done before. In some cases, estates that previously had no IHT exposure at all may find themselves with a liability.

This makes it an important time to review wills, lasting powers of attorney, and overall estate planning arrangements. It is also worth taking advice from a qualified financial adviser on the pension planning side, since decisions about how and when to draw down pension funds may need to be reconsidered in light of the new rules.

A note on timing: although the changes take effect in April 2027, their implications for estate planning are relevant now. Decisions made today about pension contributions, drawdown, and the nomination of beneficiaries may all have a bearing on the eventual IHT position.

Note: Pension tax rules are complex and subject to ongoing change. This article reflects the law as it stands at the date of publication. For guidance tailored to your circumstances, please get in touch with your solicitor.