Claire Trott: The many ways lifetime allowance changes have messed with death benefits

The announcements in the Spring Budget could have removed some of the anomalies that exist on the taxation of death benefits paid in excess of the lifetime allowance (LTA), which always appeared to be at odds with the pension freedoms and changes to death benefit taxation.

However, that is not where we find ourselves. If anything, it feels more complicated than ever, meaning an even greater need for advice in life and to support those left behind on death.

The difference between the lump sum LTA charges of 55% and the 25% charges applicable if excesses taken as income were designed initially to reflect the 40% income tax charge assumed to be payable on the income when eventually drawn.

If anything, it feels more complicated than ever

However, when the changes were introduced to remove income tax payable on pre-75 death benefits from defined contribution pension schemes, the LTA charges were not updated to reflect this for lump sums.

As such, those who opted to take a lump sum, or were forced to because of the scheme rules, were disadvantaged.

The removal of the LTA charges could have put a stop to this unfair discrepancy but it appears to be a deliberate decision to retain the differences in charges. The Spring Budget had brought in new charges to mean that, even on death, those accessing lump sums in excess of the LTA will be worse off.

This just means the complexities of pensions death benefits are even greater. That is also not the only issue beneficiaries are facing with regards to accessing their benefits and paying any appropriate taxes.

Those that receive them as a lump sum may be subject to a nasty surprise further down the line

Following a U-turn by HM Revenue & Customs, it is still the responsibility of the personal representative to report any LTA excesses to it.

With the removal of the LTA lump sum excess charge of 55%, this should have been easy, but the introduction of income tax payable on LTA lump sum excess payments still means this is needed. These are:

• Uncrystallised funds lump sum death benefit
• Defined benefits lump sum death benefit

This is an issue because, firstly, the personal representative needs to know which benefits are subject to LTA tests, and, secondly, they need to know what has previously been used.

For most people, this is something they will have never experienced dealing with.

The process on death is as follows:

1. The scheme administrator tells the personal representatives of the deceased scheme member about any benefit crystallisation events on death. This will only be for funds that haven’t been previously tested against the LTA because there is no second test on death.
2. For lump sum death benefits only, the scheme administrator reports the lump sum death benefit payment to HMRC if the payments from the scheme total more than 50% of the standard LTA.
3. The personal representatives calculate the available LTA at death and whether the benefit payment or designation is chargeable. For this, they will need to collect any information with regards to any benefits already taken, including those pre-6 April 2006. This may mean requesting relevant information from providers. They will also need to be aware of any LTA protections in place.
4. The personal representatives will need to report any amount over the individual’s LTA to HMRC. There is no set format for this and the personal representative just needs to write to HMRC.
5. Once the report is made, HMRC will follow up with the providers to establish to whom the funds have been paid, how much and in what form, so they can conduct their own calculations.
6. Once the calculations have been conducted, HMRC will assess all the individuals to whom a charge is applicable.

As you can see, there are many stages in this process and although under the new rules those who inherit pension benefits in the form of income shouldn’t need to worry, those that receive them as a lump sum may be subject to a nasty surprise further down the line.

As the charge is now income tax, the knock-on impacts to any tax planning they may be doing could be compromised. Just one more reason to ensure beneficiaries are well educated and have access to ongoing advice.

Claire Trott is divisional director, retirement and holistic planning, at St. James’s Place