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Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

Looking at what happens to your pension when you die

Historically the role of a pension was to provide an income throughout retirement, usually through the purchase of an annuity from an insurance company (unless you were lucky enough to
have a guaranteed defined benefit plan).

However, the introduction of the pension freedoms in April 2015 has dramatically increased the flexibility of product, with savvy savers often using retirement products as part of a broader tax planning strategy.

Here’s a quick guide to the treatment of pensions on death and how investing in a SIPP could help shelter your hard-earned retirement pot from the taxman.

TAX TREATMENT DEPENDS ON TYPE OF PLAN

The tax treatment of your pension on death will depend on the type of plan you have.

If you have a defined benefit (DB) pension or an annuity then normally you can’t pass on your pot after death.

Most DB pensions do come with a valuable spouse’s pension attached, usually paying out 50% of the value of your income stream after you die. You can also add a spouse’s pension to an annuity, although unsurprisingly this extra benefit will come at a cost.

However, neither of these pensions allow future generations to inherit your fund.

Defined contribution (DC) pensions such as SIPPs provide more options. Any money that is left in your pot will usually be outside of your estate for inheritance tax (IHT) purposes, meaning you won’t risk paying a 40% charge as you might with other assets above £325,000.

In fact, if you die before age 75 your fund will be paid to your loved ones tax-free, provided the money is ‘designated’ to your beneficiaries within two years of your death. ‘Designated’ just means transferring the money into your beneficiaries’ names.

If you die after age 75 any leftover funds will be taxed at your beneficiaries’ marginal rate of income tax. So for example if you leave £5,000 and your beneficiary has total income of £50,000, the inherited money will be taxed at 40% (£2,000).

TAX BILL MITIGATION

It is possible for your beneficiaries to mitigate their tax bill by choosing to take any inherited funds as an income through drawdown rather than as a single lump sum.

For example, if they have total taxable income of £30,000 and inherit a £50,000 SIPP, they might choose to take £10,000 a year (taxed at 20%) rather than taking the lot and seeing the lion’s share taxed at the higher-rate of 40%.

If your nominated beneficiary doesn’t withdraw all of the inherited pension before they die then they too can pass the money on to their loved ones, making pensions tax efficient vehicles for cascading wealth down the generations.

Tom Selby, senior analyst, AJ Bell

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