People usually want their estate to provide the best possible support for their loved ones after they pass away.

Pensions play a key role in this, as they are typically excluded from estates, meaning they are generally not liable for Inheritance Tax (IHT).

However, you may have clients who have neglected to update their pension beneficiaries, potentially leaving their retirement funds to unintended individuals.

Research reported by Unbiased found that over three-quarters of a million (773,000) people are at risk of their pension being inherited by their former partner or spouse, as they have failed to update their wishes.

Furthermore, even if your clients do update their pension beneficiaries, without proper financial planning, their heirs could face unnecessary tax burdens on their pension, reducing the overall inheritance they receive.

Read on to discover how your clients can ensure their chosen beneficiaries get the most from their inherited pension.

It is important for your clients to nominate a pension beneficiary and keep it updated

Nominating a pension beneficiary is the formal way for your clients to inform their pension provider and the trustees of the scheme who they wish to receive their pension in the event of their death. They can also request a financial planner to contact their provider on their behalf.

The provider will usually then ask that they complete an expression of wishes form, and your client may ask you, as their solicitor, to update their will.

They can change or add to their pension beneficiaries at any time, and it is a good idea to encourage them to do so after any significant life event, such as the birth of a child or grandchild, a marriage, a divorce, or the death of a loved one.

For instance, if your client’s designated pension beneficiary passes away or they go through a divorce, it’s crucial they formally update the beneficiary. Failing to do so could result in the provider either allocating a portion of the pension to their original beneficiary or deciding who inherits it on your client’s behalf.

If they have multiple beneficiaries, they can also specify how they want their pension to be split.

Designating beneficiaries is essential to ensure your client’s pension goes to the intended recipients, but it can also enhance the tax efficiency of their legacy.

For example, they could reduce the overall tax burden on their estate by leaving their pension to a beneficiary on a lower income and other assets liable for IHT to someone on a higher income, as inherited pensions are generally taxed at the recipient’s marginal rate.

By nominating and updating their beneficiaries, your clients can maximise their pensions’ tax advantages and reduce potential liabilities for their heirs.

How your client’s pension is taxed after their death depends on the type of pension and the timing of their passing

HMRC typically excludes pensions from your client’s estate, meaning they are generally not subject to IHT.

However, if they withdraw funds from the pension wrapper prior to their death, those amounts may become liable for the 40% IHT rate.

Additionally, depending on how their beneficiaries choose to access the remaining pension, they could face paying up to 45% Income Tax rate on their withdrawal, potentially reducing the value of the inheritance.

So, it’s a good idea for your client’s to carefully plan and keep the funds within the pension wrapper to maintain tax efficiency and minimise potential tax liabilities for their beneficiaries.

It can also be useful for their beneficiaries to continue working with a financial planner after your client’s passing so they can ensure their pension withdrawals are tax-efficient.

How your client’s pension is taxed after their death depends on the type of pension they have, but proper planning can help ensure it remains efficient for their beneficiaries.

Defined contribution pensions

The tax on inherited defined contribution (DC) pensions depends on your client’s age at death and whether they had already accessed their pension.

If they pass away before age 75 and have not yet drawn from their pension, their beneficiaries can inherit the pension tax-free, up to the Lump Sum and Death Benefit Allowance (LSDBA), which is set at £1,073,100 for the 2024/25 tax year.

However, if your client has already taken any tax-free cash payments, the available allowance is reduced. Any amounts exceeding the LSDBA are typically taxed at the beneficiary’s marginal Income Tax rate.

If your client passes away after age 75, their beneficiaries will pay Income Tax on the inherited pension at their marginal rate, regardless of the amount inherited.

Defined benefit pensions

If your client leaves behind a defined benefit (DB) pension, the amount their beneficiaries receive is decided by the specific rules of their pension scheme.

Typically, if they pass away before retirement, their beneficiaries will receive a lump sum calculated as a multiple of the client’s salary. This lump sum is usually tax-free if your client dies before age 75.

If your client dies after retirement, the DB pension generally continues to provide a reduced income to their beneficiaries or dependants.

However, the definition of a dependant can vary among different pension schemes, so it’s important to review the specific terms of the plan.

State Pension

If your client reached the State Pension Age after April 2016 and received the new State Pension or was going to receive it, their spouse or civil partner may be able to inherit part of it.

It will be considered part of their income and they will pay tax on it at their marginal rate.

Get in touch

If you have clients who risk leaving their pension to unintended beneficiaries or who want to optimise the retirement funds they leave behind, we can help.

Email info@blueskyifas.co.uk or call us on 0118 987 6655.

Risk warnings

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

Workplace pensions are regulated by The Pension Regulator.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.