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What happens to a pension when someone dies? If you receive a pension via inheritance, what is the process and what should you do with it? These are key questions both for estate owners (the person handing down the pension) and beneficiaries (recipients of an inheritance). Here, it helps to have an intergenerational financial plan ready, so both parties can ensure that pension money is put to best use for everyone involved.
Below, our financial planning team addresses the aforementioned questions. We hope you find this content useful. If you want to discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
020 8366 4400 or email@example.com
What happens to a pension when someone dies?
The rules differ for various pensions when someone dies. After all, there are three main types of pension in the UK: the State Pension, defined benefit (or final salary) pensions and then defined contribution pensions (pension “pots”). As a general rule, the State Pension stops paying out to its recipient when he/she dies. However, there are specific situations when a surviving spouse or civil partner can inherit some of the State Pension income.
With a final salary pension, the scheme pays an income to the member throughout retirement (based on factors such as the years of service and the average salary). Here, the particular rules of the scheme outline what happens when the member dies. Some schemes will stop all payments at this time, whilst others may offer more limited benefits to beneficiaries (e.g. children under the age of 23 who are in full-time education).
When someone passes down a pension pot (defined contribution pension), then beneficiaries’ options will be heavily dictated by what the member chose to do with the money. If the scheme had not been touched at all during his/her lifetime, for instance, then beneficiaries could take all the money as a lump sum. This is not always possible, however, in which case they may be able to move the pension to another scheme which allows this.
In many cases, the member chose to take a flexible retirement income – meaning he/she is in pension drawdown at the time of death. Here, the beneficiaries could withdraw any remaining pension money as a lump sum. If the member chose to use their pension to buy an annuity, on the other hand, then the annuity product in question will determine what is still payable. Some (e.g. “joint life” products) will continue to pay out a share of the income, whilst others (e.g. single life options) typically stop when the owner dies.
What to do with an inherited pension pot?
Assuming you can withdraw money from the pension(s) you have inherited, what should you do with it? First of all, you need to consider the estate owner’s age when they died. If they were 75 or over when it happened, then any income you receive as earnings will be taxed at your rate of Income Tax. This could push you into a higher tax bracket if you are not careful, which can have knock-on effects onto the rest of your financial plan.
Here, you could opt to take the money as flexible retirement income (pension drawdown). This would mean that you would not be taxed on the full pension value you inherited, but you would only be taxed on the income taken within a given tax year. However, only those aged 55 can take money via drawdown from a defined contribution pension here in the UK (set to rise to 57 in the future). So, if you are younger than 55 when you receive a pension inheritance, then this may inevitably be added to your Income Tax bill. Speak with a financial adviser if you think you may be affected by this.
Once all of the inheritance tax (IHT) and Income Tax considerations are addressed, however, it is time to discern the best use of your pension inheritance. Here, there are a range of options you can consider. Their suitability and priority will largely depend on your financial situation and goals, and include:
- Paying off expensive debts. If you have a large unpaid credit card bill or unpaid personal loan, then this could be an opportunity to get rid of it. High-interest debts are a big drain on your monthly finances and credit score.
- Building up your emergency buffer. It is generally a good idea to have 3-6 months’ worth of cash in an easy-access account, in case you lose your job or need to pay to deal with a family emergency. A pension inheritance can help you replenish it.
- Build up your own pension. You need to consider your own retirement, even if it may seem a long way off. Investing a lump sum into your pension could give you a nice boost to move you towards your long-term financial goals. Another benefit here is that the UK government will “top up” any contribution you make according to your Income Tax rate (with contributions capped at £40,000 per tax year or up to 100% of your earnings – whichever is the lowest).
Interested in discussing your financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team here at Cedar House via a free, no-commitment consultation:
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