Who gains from my pension if I die?

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Denise Brewster's recent fight to benefit from her late partner's pension - resolved last month after a seven-year struggle - has shown the cruel consequences of finding yourself on the wrong side of arcane pension rules. It was a long and sad battle that, at last, produced succour for Ms Brewster.

She had been living with Lenny McMullan for 10 years before his sudden death, on Boxing Day in 2009.

As unmarried cohabitees, the rules governing Mr McMullan's local government pension scheme required a form to be filled in naming her as the beneficiary, whereas married spouses would get this recognition automatically.

The result was that, following his death, Ms Brewster, from Coleraine in Northern Ireland, was denied the money. It took more than seven years for judges at the Supreme Court to agree that the interpretation of the rules was unfair.

Unfortunately, this is not the only example of imbalances in the rules around inheriting pension money. What happens to your retirement savings when you die depends on the type of pension, the rules that govern it and your age at death.

Tax is a big consideration, and the rules have now grown so complicated that many ordinary people need to carefully arrange their finances to avoid a needless charge on the sums they leave behind.

So here's what happens to your pension when you die.

DEFINED CONTRIBUTION PENSIONS

These are the pension pots that you pay into over your working life, with what you pay in benefiting from tax relief. They could be private pensions, including self-invested personal pensions (Sipps), or occupational schemes where your employer contributes as well.

Here the rules are relatively straightforward - and generous. Drawdown death benefits changed in 2015 and the result has been that more and more people are using defined contribution pensions to maximise what they can potentially pass on to heirs.

If you die before the age of 75, anything in your defined contribution pensions can be passed on to anyone you wish and the recipient won't have to pay tax on it, as long as this is done within two years of the date of death.

You can express to the company running the pension who you would like to benefit when you die.

The money is not normally part of your estate, so no inheritance tax is due.

Bear in mind, however, that if you have already started accessing your money, anything that you have withdrawn, including the potential 25 per cent of it that is available to you tax-free, would fall inside your estate and therefore be liable for inheritance tax.

For funds still within the pension at death, beneficiaries can get the money in a drawdown account. They can withdraw some or all of it, or take an income as if it were their own pension. They don't have to be of pension age to get the money.

This assumes that you are within your own lifetime allowance for pension savings - currently £1 million for most - when you die. If not, then a charge may apply before the money is passed on.

If death occurs after age 75, then the recipient must pay income tax on the money when they withdraw it from the drawdown account.

This can limit their options because, in order to avoid an abnormally high tax bill, they may wish to take the money in chunks small enough that it does not push their income above the higher-rate thresholds.

ANNUITIES

Annuities take the money you have saved in defined contribution pensions, and pay a guaranteed income for life in return. What happens if you die after that depends on the terms of the annuity.

You can elect to include death benefits with an annuity, although this will reduce the income you get overall. A 'joint life' annuity will continue to pay an income to a spouse or civil partner, at an agreed rate - 50 or 100 per cent of the income, for example.

Annuities can also include a guaranteed period - up to 30 years is possible. Die within that time and an income will continue to be paid until the end of the term.

Some annuities give 100 per cent value protection - which means you get back your money minus any income or tax-free cash you have received.

DEFINED BENEFIT PENSIONS

Defined benefit pensions are occupational plans that entitle you to a retirement income for life, typically based on your years of service at a company. Some are referred to as 'final salary' schemes.

These have historically been more generous than defined contribution schemes, and more expensive to provide. As a result, there are fewer of them these days and they are often closed to new members. Public sector work is one area where they are still common.

Unlike defined contribution schemes, there is no pot of money building up, but rather a promise by the scheme to one day pay an income to members.

You may have to pay money in, but the income it provides does not depend on contributions, while any death benefits depend on the terms of scheme.

Crucially, death benefits from defined benefit schemes will be taxed at the recipient's rate of income tax.

This contrasts to the tax-free options for defined contribution schemes and is one of the reasons that some people are choosing to transfer their generous defined benefit scheme to a Sipp, for example.

Death benefits are likely to be higher if you're a still an active member of the scheme - which usually means you are still an employee of the company providing it.

If you have left, some schemes may only return the contributions you made, rather than benefits linked to the income you had been promised.

For still active members, death benefits are typically limited to spouses (or civil partners) and financial dependents - which usually means children living at home under the age of 18, or 23 if they are in full-time education.

If you were to die after starting to take an income from the pension, some of it may continue to be paid to your spouse or dependents, depending on the scheme's rules.

Some schemes have guaranteed periods in the event of death, within which the full income is paid to the beneficiaries for a specified period. Outside of any guaranteed period, beneficiaries may get only a proportion of the full income - a level of between half and two-thirds is typical.

If you were to die before you start taking an income, beneficiaries might get a proportion of the 'accrued' benefits, which will be lower.

Some schemes have clauses that reduce or remove death benefits to a spouse if they are more than 10 years younger than the scheme member, as a means to reduce liabilities on the scheme.

It is also common for schemes to offer life assurance for active members - this is separate from the death benefits discussed here.

STATE PENSION

Despite state pensions being the one retirement income that almost everyone will get, the rules are even more complex here than anywhere else.

There used to be a 'widow's state pension' that spouses of people who died while drawing their state pension could receive. This has now been replaced by various other benefits - the Bereavement Payment, the Widowed Parent's Allowance and the Bereavement Allowance.

It is also possible for surviving wives to benefit from the National Insurance contributions paid by deceased husbands that reached pension age before April last year.

As much as 60 per cent of the pension can be passed on this way.

The rules for these benefits are complex and you will need to check your eligibility for each with the Pension Service.

Ed Monk is associate director for personal investing at Fidelity International.


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Comments

Tax at 75

Is there any likelihood or pressure to raise the limit on taxing a pension above 75? It seems a young age to penalise people maybe struggling with care home costs etc. Doesn't it also encourage people to drawdown more than they might want or need?

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