Property passing outside the estate - Pension scheme benefit...

Learning Outcomes

This article explains when and why pension scheme death benefits pass outside a deceased’s estate, the legal and tax consequences, and the application of the relevant rules to SQE1-style scenarios. It discusses the role of trustee discretion, the effect of nominations, and the inheritance tax treatment of pension benefits, highlighting key distinctions based on age at death and recent case law. It also outlines the differences between trust- and contract-based pension arrangements for succession and tax purposes, identifies when scheme rules require payment to the estate, examines the impact of pre-death transfers or omissions on IHT, and details the current income tax regime for death benefits, including the age 75 distinction and the operation of the Lump Sum and Death Benefit Allowance.

SQE1 Syllabus

For SQE1, you are required to understand how pension scheme benefits may pass outside the estate and the implications for estate administration and inheritance tax, with a focus on the following syllabus points:

• The distinction between estate and non-estate assets for succession and tax purposes
• The legal structure of pension schemes and the effect of trust law
• The role of trustee discretion and member nominations in pension death benefits
• The inheritance tax (IHT) treatment of pension scheme benefits
• The impact of member actions and recent case law on IHT liability
• The difference between trust-based occupational schemes and contract-based personal pensions, and how each pays death benefits
• The income tax treatment of beneficiaries’ death benefits, including the significance of age 75 and the Lump Sum and Death Benefit Allowance
• When a grant is not required because benefits are paid directly to beneficiaries, bypassing personal representatives (PRs)

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Why do most pension scheme death benefits not form part of a deceased member’s estate for inheritance tax purposes?
2. What is the legal effect of a member’s “expression of wish” form in relation to pension death benefits?
3. How does the age of the member at death affect the income tax treatment of pension death benefits for beneficiaries?
4. In what circumstances might a transfer of pension rights before death be treated as a transfer of value for IHT purposes?

Introduction

Pension scheme benefits can represent significant value on death, but in many cases these benefits do not pass under the deceased’s will or intestacy. Instead, they are paid at the discretion of pension scheme trustees (or scheme administrators), often outside the estate. Understanding the legal structure, the effect of nominations, and the inheritance tax treatment is essential for SQE1. It is also important to recognise that some schemes still require a payment to the estate, in which case the benefit will be included for succession and IHT purposes. Finally, the income tax position for recipients depends crucially on the member’s age at death, and the current regime places limits on tax‑free lump sums paid on death.

Key Term: pension scheme death benefit
A lump sum or other payment made from a pension scheme on the death of a member, usually at the discretion of the scheme trustees or scheme administrator.

Key Term: trust-based pension scheme
A pension arrangement where assets are held by trustees for the benefit of members and their beneficiaries, separate from the member’s personal estate.

Key Term: death in service benefit
A lump sum payable on the death of an employee while still employed and a member of the scheme, typically calculated as a multiple of salary and paid at trustee discretion.

Pension scheme benefits and the estate

Pension death benefits are usually paid under a trust structure. The assets of the pension scheme are held by trustees, not by the member personally. This means that, on the member’s death, the benefits are not part of the member’s estate for succession or inheritance tax purposes unless the scheme rules require payment to the estate.

Many occupational schemes are trust-based. Personal pensions are usually contract-based with an insurer, but commonly the provider (as scheme administrator) retains a discretion over the destination of death benefits, similar in effect to trustee discretion, so that benefits are paid directly to chosen recipients rather than to the estate. Whether trust- or contract-based, it is the presence of genuine discretion and the absence of any member entitlement to direct payment to the estate that keeps the benefit outside the estate.

Pension death benefits typically take one of two forms:

• A lump sum (for example, a death in service payment or a lump sum from undrawn defined contribution funds)
• An ongoing income for a dependant or other permitted beneficiary (for example, a dependant’s or nominee’s pension/drawdown)

In both cases, where paid under proper trustee/administrator discretion, the benefit bypasses the PRs, is not governed by the will or intestacy and, in principle, does not form part of the deceased’s IHT estate.

Key Term: expression of wish (pensions)
A non-binding written indication by a pension scheme member of preferred beneficiaries for death benefits, used to guide trustee discretion.

Key Term: dependant (pensions)
For pensions tax purposes, broadly a spouse or civil partner, a child under 23 (or older if dependent due to impairment), or any person financially dependent on the member.

Key Term: nominee (pensions)
An individual or entity nominated (by the member or selected by the scheme administrator where permitted) to receive death benefits who is not necessarily a dependant.

Key Term: successor (pensions)
A person nominated to receive death benefits following the death of a dependant or nominee beneficiary, enabling benefits to be passed on more than once.

Trustee discretion and member nominations

Most modern pension schemes give trustees (or scheme administrators) discretion to decide who should receive death benefits. The member can indicate their wishes by completing an “expression of wish” or nomination form, but this is not binding. The trustees must consider the form but are not obliged to follow it. In practice, trustees will normally give significant weight to the member’s latest, validly completed expression of wish, but they are required to consider the potential class of beneficiaries (which often includes spouse/civil partner, children, financial dependants, nominees and sometimes the estate) and to exercise discretion reasonably and in accordance with the scheme rules and trust law.

Trustee discretion is essential. If the scheme rules require payment to the estate or a specific person without any discretion, the benefit may fall into the estate and be subject to inheritance tax. If the trustees have discretion and exercise it properly, the benefit is not part of the estate. A member’s choice to nominate the estate (where the scheme allows that) risks bringing the benefit into the estate for IHT; however, many schemes expressly avoid binding nominations to the estate to preserve discretionary payment and keep any death grant outside IHT.

Members should periodically review expressions of wish to ensure they reflect current circumstances (for example, marriage, divorce, new children or financial dependants). An outdated expression of wish does not bind trustees and can be overridden if the trustee evidence indicates a more appropriate beneficiary within the permitted class.

Worked Example 1.1

A member of a workplace pension scheme dies, having nominated her son as beneficiary on the scheme’s expression of wish form. The scheme rules give trustees absolute discretion. The trustees pay the lump sum to the son.

Answer:
The benefit is paid outside the estate, following trustee discretion. The son receives the lump sum directly. It does not pass under the will or intestacy and is not subject to IHT as part of the estate.

Worked Example 1.2

A cohabiting member had an expression of wish in favour of a former spouse executed 10 years ago. At death, the member’s partner and minor child were financially dependent. Trustees, exercising discretion, pay the lump sum to the partner and create a beneficiary’s drawdown for the child.

Answer:
The payments pass outside the estate. The expression of wish was considered but not followed. Trustee discretion was properly exercised in favour of current dependants within the permitted class.

Inheritance tax treatment

Where trustees have discretion, pension death benefits are not usually subject to inheritance tax as part of the deceased’s estate. This is because the member did not have a beneficial entitlement to the funds or control over their destination at death; the property is held on trust and paid under a discretionary power.

However, IHT may arise in limited circumstances:

• If the member transfers pension rights or makes changes to the scheme arrangements with a gratuitous intent to benefit others, and as a result reduces their estate, HMRC may treat this as a transfer of value for IHT. Timing (such as proximity to death or serious ill health) is relevant but not determinative; the key questions are whether there was a loss to the estate and whether the disposition was intended to confer a gratuitous benefit.

• If the scheme rules require payment to the estate (or the member makes a binding direction to pay to the estate), the benefit is included in the estate for IHT and passes under the will or intestacy.

• Deliberate omissions by a member to exercise rights (for example, choosing not to draw benefits) may, in limited circumstances, be treated as a transfer under IHTA 1984 s.3(3). The availability of this anti-avoidance rule turns on the nature of the right and whether the omission causes an increase in another person’s estate; recent authority has confined its operation in the pensions context.

Key Term: transfer of value (IHT)
A disposition by which the value of a person’s estate is reduced, potentially triggering inheritance tax.

Key Term: omission to exercise a right (IHT)
Under IHTA 1984 s.3(3), a deliberate failure to exercise a right that results in an increase in another person’s estate may be treated as a transfer for IHT in limited circumstances.

Worked Example 1.3

A member, aged 68, transfers funds from a personal pension to a new scheme and dies six months later. The transfer increased the value of death benefits for his children.

Answer:
HMRC may investigate whether the transfer was a transfer of value for IHT. If the main motive was to benefit the children (or there was an intention to confer a gratuitous benefit) and the transfer reduced the value of the member’s estate, IHT could be charged on the increase in value. The proximity to death and the member’s health will be relevant evidential factors.

Exam Warning

If a member is in serious ill health and makes changes to pension arrangements shortly before death, HMRC may treat this as a transfer of value for IHT. Always check the facts, motives, scheme terms, and timing. Not all pension transfers are chargeable; the intention and effect of the transaction are critical.

Worked Example 1.4

Under an older occupational scheme, the rules require that any death-in-service lump sum be paid to the member’s personal representatives. The member dies while still employed.

Answer:
The lump sum forms part of the estate, is included in the IHT calculation, and will pass under the will or intestacy. A grant will be required to collect it.

Income tax on pension death benefits

The income tax treatment of pension death benefits depends on the member’s age at death and on the type of benefit and timing of payment:

• If the member dies before age 75:

  • Most lump sum death benefits and beneficiary’s drawdown/annuity payments from defined contribution arrangements are paid tax-free to recipients, provided and to the extent they are within the deceased’s remaining Lump Sum and Death Benefit Allowance and (for certain lump sums) are paid within the statutory two‑year period.
  • Dependants’ scheme pensions from defined benefit schemes are generally taxable as the recipient’s income, even if the member died before 75.

• If the member dies at or after age 75:

  • Payments to beneficiaries (lump sums and income) are taxed as the recipient’s income at their marginal rate.

Two operational points are frequently tested:

• A two‑year payment window applies to certain lump sums paid on death before 75. If payment (or allocation/designation) is made after that window, income tax may apply to the recipient even where the member died before 75.
• From 6 April 2024, the lifetime allowance has been abolished and replaced with the Lump Sum and Death Benefit Allowance. Tax‑free lump sums on death before 75 are limited to the available allowance; any excess is taxable as the recipient’s income.

Key Term: marginal income tax rate
The highest rate of income tax that applies to a person’s income in a tax year.

Key Term: Lump Sum and Death Benefit Allowance (LSDBA)
A limit applying to the total tax‑free lump sums (including death benefits) that can be paid; lump sums in excess are taxable as recipients’ income.

Key Term: two-year rule (pension death benefits)
For certain lump sum death benefits on death before 75, scheme administrators have two years from when they knew or could reasonably have known of the death to pay or designate the benefit for it to qualify for tax‑free treatment (subject to allowances). Payment outside this window can trigger income tax on recipients.

Worked Example 1.5

A member dies at age 72. The trustees pay a lump sum to the member’s spouse within 10 months.

Answer:
The lump sum is paid tax‑free (subject to the deceased’s remaining LSDBA), as the member died before age 75 and payment was within two years of death.

Worked Example 1.6

A member dies at age 80. The trustees pay a lump sum to the member’s adult child.

Answer:
The lump sum is taxed as the child’s income at their marginal rate, as the member died after age 75.

Worked Example 1.7

A member dies at age 60 leaving a defined benefit pension that provides a dependant’s scheme pension to the surviving civil partner.

Answer:
The dependant’s scheme pension is taxable as the recipient’s income even though the member died before 75. The pre‑75 tax‑free rule primarily applies to beneficiary’s drawdown/annuity from defined contribution funds and certain lump sums, subject to allowances and timing.

Worked Example 1.8

A member dies at age 70 with uncrystallised defined contribution funds. Trustees delay paying a lump sum and make payment after three years.

Answer:
Because payment was made outside the two‑year window, the lump sum is taxable as the recipient’s income (to the extent required by the current regime), notwithstanding the member died before 75. The LSDBA may still apply to determine the extent of any tax‑free element.

The effect of scheme rules

Not all pension schemes operate in the same way. Some older schemes or certain occupational pensions may require payment of death benefits to the member’s estate. In these cases, the benefit forms part of the estate and is subject to IHT and the terms of the will or intestacy. Conversely, where trustees (or scheme administrators) have genuine discretion, and they exercise it properly, the benefit is not part of the estate and is paid directly to beneficiaries without the need for a grant.

From a practical administration standpoint, death benefits paid outside the estate can be obtained quickly on production of a death certificate and any documentation required by the scheme, providing important liquidity to dependants. Where death benefits are paid to the estate, the PRs must obtain the grant before collecting the funds, and those funds will be available to meet estate liabilities, including IHT.

Key Term: estate (for succession and IHT)
The property to which a deceased person was beneficially entitled at death, passing under their will or intestacy and subject to inheritance tax.

Worked Example 1.9

A personal pension is contract‑based. The scheme administrator has discretion to pay a death benefit to dependants or nominees. The member’s expression of wish favours a cohabiting partner. The administrator pays the lump sum to the partner.

Answer:
The benefit passes outside the estate. Although contract‑based, the administrator’s discretion functions like trustee discretion. The expression of wish guided (but did not bind) the decision.

Recent case law: HMRC v Parry (Staveley)

The Supreme Court in HMRC v Parry & Others [2020] UKSC 35 considered whether pre‑death actions affecting pension rights were transfers of value for IHT. The deceased transferred funds from one pension arrangement to another and died shortly afterwards. HMRC alleged (1) a transfer of value on the transfer between schemes, and (2) a transfer by omission under IHTA 1984 s.3(3) because the deceased did not take benefits before death.

The Supreme Court drew two important distinctions:

• Not all pension transfers are chargeable transfers for IHT. The key question is whether the transaction reduced the value of the member’s estate and was intended (at least in part) to confer a gratuitous benefit on others. On the facts, the transfer to the new pension was a transfer of value because it changed the destination of death benefits in a way that increased others’ prospects at the expense of the estate.

• The omission to exercise pension rights (not drawing benefits before death) did not amount to a transfer under s.3(3) on the facts of that case. The Court took a narrow view of the provision’s application to pension rights, and the omission was not treated as a taxable transfer.

Parry therefore confirms that routine operation of trustee discretion on death does not give rise to IHT; however, certain member actions shortly before death can. In problem questions, isolate (1) whether there was a “disposition” or omission by the member, (2) whether it caused a loss to the estate and conferred a gratuitous benefit on others, and (3) whether the scheme’s structure meant the benefit was paid at discretion or to the estate.

Revision Tip

For SQE1, focus on the facts: Was there a transfer of value? Was the benefit paid at trustee discretion? Did the scheme rules require payment to the estate? Consider timing, the member’s health and motives, and apply Parry’s reasoning.

Summary Table: Pension death benefits and the estate

Note: Many contract-based personal pensions also operate with administrator discretion akin to trustee discretion; in those cases they are treated like the first row (passing outside the estate).

Key Point Checklist

This article has covered the following key knowledge points:

• Pension death benefits are usually held in trust or administered with discretion, so do not form part of the estate for succession or IHT.
• Member nominations (expression of wish) are not binding but guide trustee/administrator discretion; keep them up to date.
• Where trustees/administrators have discretion and exercise it properly, benefits are not subject to IHT as part of the estate and are paid directly to beneficiaries without a grant.
• If the scheme rules require payment to the estate (or a binding direction to the estate exists), the benefit is included in the estate and subject to IHT and the will/intestacy.
• Death in service benefits are often substantial and typically paid at discretion; they normally bypass the estate.
• IHT can arise where the member makes pre‑death changes (e.g., transfers) intended to confer a gratuitous benefit and reducing the estate’s value; Parry (Staveley) clarifies that not all pension transfers are chargeable and confines the “omission” rule.
• Income tax on pension death benefits depends on age at death and benefit type:
  • Death before 75: most DC lump sums and beneficiary’s drawdown/annuity can be tax‑free within the LSDBA and (for certain lump sums) if paid within two years; DB dependants’ scheme pensions remain taxable.
  • Death at/after 75: recipient is taxed at their marginal rate.
• From April 2024, the Lump Sum and Death Benefit Allowance limits the total tax‑free lump sums on death; excess lump sums are taxable as recipients’ income.
• Do not confuse pension expressions of wish (non‑binding) with statutory nominations for certain savings products (binding); the legal effects differ.
• In practice, benefits paid outside the estate can provide immediate financial support to dependants; where paid to the estate, a grant is required and the funds are available for estate liabilities.

Key Terms and Concepts

• pension scheme death benefit
• trust-based pension scheme
• expression of wish (pensions)
• death in service benefit
• dependant (pensions)
• nominee (pensions)
• successor (pensions)
• transfer of value (IHT)
• omission to exercise a right (IHT)
• marginal income tax rate
• Lump Sum and Death Benefit Allowance (LSDBA)
• two-year rule (pension death benefits)
• estate (for succession and IHT)