Changes over the years

Over the years, the differences in the rates of the LTA excess tax charge became more notable. The introduction of additional rate income tax, reductions in the lifetime allowance and changes to pension death benefit taxation, all made the original logic for the 25% and 55% tax charges less sound. 

In particular, the removal of tax on most pension death benefits where a member died before age 75 created a clear tax discrepancy. With income tax no longer payable, the overall tax was simply 55% when taken as a lump sum or 25% if taken as pension income. This made it far preferable to take death benefits as pension income, as benefits could still be withdrawn in full via flexi-access drawdown.

Changes for the 2023/24 tax year

Since 6 April 2023, the lifetime allowance remains, but the lifetime allowance charge has been abolished. Yet, the inconsistent approach to taxation of death benefits continues.

For the 2023/24 tax year, where a scheme member of a money purchase scheme dies before age 75 and uncrystallised benefits are paid out, a BCE will still occur (as long as benefits are dealt with within the relevant 2 year period).

However, where there is LTA excess which is taken as beneficiary’s income (annuity or drawdown), the 25% LTA charge has been completely removed. This means the LTA excess can be taken tax free.

Similarly, where the beneficiary is paid a lump sum, the former 55% LTA charge is also removed. Unfortunately, unlike the income option, it cannot be paid tax free. Instead, the excess is now charged to tax at the beneficiary’s marginal rate under PAYE. 

This creates a clear advantage in taking any LTA excess as beneficiary’s drawdown, as the funds can be drawn immediately and free of tax, rather than suffer an income tax charge for the beneficiary.

Example 

John dies aged 70 in the 2023/24 tax year. He had £100,000 of lifetime allowance remaining and £300,000 of uncrystallised pension benefits. The uncrystallised funds are shared equally between his two children, Anna and Brian. Anna is paid a lump sum death benefit (causing BCE7) and Brian opts for beneficiary’s drawdown (causing BCE5C). 

There is a lifetime allowance excess of £200,000, which must be apportioned equally across the death benefits. Therefore £100,000 is apportioned to Anna and £100,000 to Brian.

As Anna was paid a lump sum, the £100,000 lifetime allowance excess is added to her taxable income for the year. This moves her into higher rate tax and if she has any other income, will cause the erosion of her personal allowance, and potentially make her an additional rate taxpayer.

As Brian opted for beneficiary’s drawdown, the £100,000 of lifetime allowance excess is not taxable and can be withdrawn tax free. 

Where the excess can’t be taken as income  

Although it is clearly preferable to take lifetime allowance excess as income, in some circumstances, this will not be possible and a taxable lump sum will be the only option. This will typically be in the following situations:

• Where the beneficiary does not qualify as a dependant, nominee or successor of the member – often a child aged over 23 who hasn’t been nominated
• Death benefits due under a defined benefit scheme – defined benefit schemes are not able to offer drawdown or annuity death benefits. 
• Death in service benefits written under a pension scheme, usually paying a multiple of salary (e.g. 4x) – as this is written as a defined benefit, it can normally only be paid as a lump sum.

Comment 

Although the lifetime allowance charge has been removed, a large lump sum that is subject to income tax can still result in a significant tax charge. 

This provides yet another reason why individuals should ensure death benefit nominations or expressions of wishes are worded appropriately. By including mention of all family members or friends that might eventually benefit, you can ensure that they all potentially qualify as a nominee and no-one might be forced to take a lump sum. 

Important Information

Please note this is for general information only and is based on LV=’s understanding of the relevant legislation and regulations and may be subject to change.

The tax treatment of benefits depends on individual circumstances, and may be subject to change in the future.

The use of this document is at your own risk, and the content should not be used for the provision of professional advice.

LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.