This is one of the key areas in which annuities and income drawdown differ, so it is very important to understand the differences. This is based on our understanding of current tax and pensions rules which can change. The tax situation depends on your individual circumstances. If you are worried about tax charges on death, you should seek advice from a tax professional.
The death benefits available will depend on the type of option you have chosen.
There are three possible types of death benefit you can include in an annuity. You have to make your choice at the outset and once your annuity has been set up you cannot normally change it.
1. You can select a spouse’s pension at the outset. In this case, after your death, payments will continue to be made until their death. The higher the level of spouse’s pension you choose, the lower your starting income will be. If you outlive your spouse, the money you have used to buy their additional pension will have been wasted. However if you die before your spouse, you should consider whether they would have sufficient income without your annuity. Contracted out pensions require that in the event of your death, your annuity continues to provide 50% of the income to your spouse or civil partner for the rest of their lifetime.
2. You can choose a guarantee period of up to ten years which starts on the commencement of your annuity payments. This means your annuity income will be paid out for the guarantee period even if you die before then. If you survive the guarantee period, the income will be paid for the rest of your lifetime. Like all other benefits on an annuity a guarantee period will lower your own starting income. Contracted out pensions only allow guarantee periods of up to 5 years.
3. You can buy a value protected annuity where an amount up to the original purchase price, less any gross income payments received, can be returned less 55% tax (note this tax charge is not inheritance tax). Where benefits are paid on a discretionary basis, the lump sum would not normally be subject to an inheritance tax charge.
Pension Income drawdown (until 6th April 2011 known as Unsecured Pension/USP).
The death benefits under pension income drawdown are generally more favourable than under an annuity. This is a popular reason for people to enter pension income drawdown. If you die whilst in income drawdown there are several options for the remaining pension fund including:
1. Your dependant could carry on with pension income drawdown until their death. Any income taken would be taxable.
2. Your dependant could take the fund and buy a lifetime annuity with it. The income from this annuity is taxable.
3. Any beneficiary could receive some or the entire remaining funds as a lump sum less a 55% tax charge (note this tax charge is not inheritance tax).
4. Contracted out pensions require that an income is made available for a surviving spouse or civil partner. Only where there is no spouse or civil partner may the fund be passed to another nominated beneficiary. A lump sum payment would be subject to the 55% tax charge.
It is possible for you to have various types of pension funds or benefits on death and each one would be treated separately according to their own rules. For example, you could have an annuity and an income drawdown plan (subject to the rules of each option) and also some funds from which you have not taken benefits.
‘Third Way’ (Fixed Term Annuities)
At the start of the plan, you can choose the level of benefits that will be paid if you die before the end of the term. The death benefits that are available are:
1. Dependant’s income
If you die during the term of the plan you can choose to provide your spouse, civil partner or financial dependent with an income. The surviving dependant will be paid an income equal to the chosen percentage of your income until either the end of the plan or until they die – whichever happens first. If your dependant survives until the end of the term, the provider will pay out the chosen percentage of the maturity value
2. Guarantee period
This allows you to protect your income for a set period of time. If you die within the guaranteed period, the remaining income less tax (now 55%) will be paid as a lump sum.
If your plan also includes a dependant’s income benefit and, if your dependent is still alive when you die, your income will continue to be paid at the full amount until the end of the guaranteed period. If your dependent is still alive at the end of the guaranteed period, the dependant’s income will be paid.
If your dependent dies within the guaranteed period, the remaining income less tax (now 55%) will be paid as a lump sum.
3. Value protection
Value Protection allows you to protect up to 100% of your original investment if you die within the plan term.
The lump sum payable will be the initial amount used to purchase the Protected Retirement Plan (or you can choose to protect a proportion of this amount), less the total amount of income paid. Any lump sum payable will be subject to a 55% tax charge.