What to think about when inheriting a pension

Pensions are there to give us an income in retirement, but they can also be one of the largest assets that are passed on after death. Loved ones may find themselves in the position of inheriting a pension income or even a pension pot of money. The details can vary depending on the type of pension the person had, such as whether it’s paid as an income or lump sum, and how it is taxed.

This area can be difficult to navigate; but we are here to help you make sense of it all.

Women are more likely to die later than men

There are more baby boys born than baby girls, but the number of women overtakes the number of men at the age of 27, and by their 90s there are almost twice as many women as men. This is because not only do women tend to live longer, but those marrying a male partner, tend to marry someone slightly older on average, increasing the chance they could outlive him.

This means women are likely to inherit at least some of their husband’s assets, sometimes including their pensions.

Inheriting a pension income

If your partner was receiving an income from a defined benefit scheme – such as a public sector scheme –that will likely continue to be paid to you when they die, whether you were married or not. However, it is likely to be at a lower rate than what your partner received, often half the income previously being paid. This income will be taxable in your hands.

You may also receive an income if your partner bought an annuity and set it up to pay an income to you when they died. This won’t be subject to income tax if they died before age 75 but will be if they were 75 or older.

In these cases, the pension income will normally be paid to you for as long as you live but will stop on your death.

Inheriting a lump sum

You could receive a lump sum payment from a defined benefit scheme if your partner died whilst still working for the employer attached to that scheme. This is usually tax free.

You could also receive a lump sum from a defined contribution scheme, where contributions are paid into a pot of money that benefits from investment growth. There are a few scenarios where this may happen: your partner bought an annuity and chose certain features, had not yet accessed their pension pot, ; or had moved it into drawdown and not yet used up all the drawdown pot.

This lump sum will usually be taxable if they died age 75 or over, but in most cases will be income tax free if they died before age 75.

Drawdown or pension money not yet accessed

If your partner died before accessing their pension, or after moving it into drawdown, the remaining money could be placed in a drawdown fund for you, where the money can be paid as ongoing income. This option may be available if you were their spouse or civil partner, depended on them financially, or had been nominated by them. You could then withdraw this money whenever you want, even if it’s before you reach the age where you can access your own pension.

If you did not fall into one of these categories—for example, if you were neither a spouse nor a nominated beneficiary—the pension might instead have to be paid to you as a lump sum.

If your partner died before age 75 then the payments are usually income tax free. If they were older, then the withdrawals will be subject to income tax. If you die before your inherited drawdown fund runs out, you could pass any unused money onto your loved ones. This may be paid as a lump sum to them, or if they are dependent on you for money or you nominate them, it can be paid as an ongoing income. Whether their withdrawals will be subject to income tax will depend on whether you are younger or older than 75 when you die, not the original owner of the pension.

Setting a strategy

If you inherit a drawdown fund then it becomes your responsibility to manage that fund, including deciding where that money is invested and deciding how much money to take and when. This is very important if you want your pension pot to carry on, giving you an income for life.

These are tricky decisions. But your pension provider should be able to give you information and support or you can pay a regulated financial adviser to set a plan for you.

What about inheritance tax

Income tax is not the only tax you could pay on inherited pension money. From April next year, any money kept in a pension pot or unused money in a drawdown pot will be included in people’s estate when working out if inheritance tax (IHT) is due.

If you are married or in a civil partnership, then any money passed to you will be exempt from IHT.

But if you were unmarried partners, then IHT could be due. Your partner’s executors or personal representatives are responsible for working out how much, if any, IHT is due on the pension money depending on your partner’s total wealth and allowances. They can ask the pension scheme to pay the IHT due directly to the government. Alternatively, the estate could pay it, or the person receiving the pension money.

If you inherit a pension or have pension money of your own, then on your death the value of your estate including any unused pension funds will also be assessed for IHT.

This is a very complicated area so it’s best to have conversations with your partner now about what happens to both your pension funds on death. That way you can decide a plan together that works for you both. Depending on your overall wealth, and your pension wealth, that may mean moving money out of the pension now – to spend or gift to others, or invest elsewhere - to avoid leaving you with a big IHT bill.

But ultimately, setting a plan means you both get to enjoy a comfortable pension income throughout your lives, regardless of who dies first and when.