Little-known rules regarding ‘death-in-service’ payouts from workplace pension schemes could see grieving families hit by shock five-figure tax bills.
That’s according to Royal London which says millions of employees are at risk of exceeding the pension lifetime allowance because of their death-in-service benefits. As a result, it’s calling for a change in the rules.
Many company pension schemes offer workers’ families a lump sum ‘death-in-service’ payment of up to four times the employee’s annual salary if they die while employed by the firm.
But a little-known caveat of this payment is that it can count against the £1 million lifetime allowance limit for tax-relieved pension contributions.
For example, say you earn £100,000 and have death-in-service benefits worth four times your salary. If you die before you stop working, the £400,000 payment would count towards your lifetime allowance. If you already had more than £600,000 in your pension pot, your heirs would end up paying tax of 55 per cent on the excess.
In some cases, this will generate an unexpected tax bill running into tens of thousands of pounds, leaving your family a lot less money than expected.
Royal London has found this problem has become more acute since the lifetime allowance was reduced from £1.25 million to £1 million in April 2016. In 2010 the allowance stood at £1.8 million but has been reduced steadily since then, due to a number of pension reforms.
The lifetime allowance will be frozen at £1 million until 2018 and then rise in line with inflation. This means that, as earnings grow, more and more people will potentially be dragged into the tax trap – so it’s not simply an issue for the super-rich.
To make matters more complex, only life assurance benefits with a particular legal structure – those written under trust within an approved pension scheme – count towards the limit. Life assurance benefits from something called an ‘excepted group life policy’ appear not to be counted, although if HMRC thinks this method has been used purely to avoid tax then it can levy a tax charge in any case.
‘It is hard enough dealing with the loss of a loved one without having to face a huge tax bill as well. It is ridiculous to say that someone who has died has saved ‘too much’ into a pension because they were unfortunate enough to die prematurely,’ says Royal London’s director of policy Steve Webb. ‘In addition, the fact that some types of life cover count for tax and others apparently do not means that individuals do not know where they stand. The government needs to review these rules as a matter of urgency to end the distress being experienced by bereaved families. It is also important that employers ensure that workers are told if this issue could apply to them, and that employees ask searching questions of their pension scheme’.
Webb cites the example of a 59-year-old widow who recently received an unexpected tax bill. Mrs B’s 51-year-old husband died in February 2016 just 12 weeks after being diagnosed with cancer.
‘The week before his death our adviser ascertained from his employer that the death-in-service benefit should form part of his lifetime allowance. This was a complete shock to us. As a result, the death-in-service benefit I received amounts to nearly 60 per cent of his lifetime allowance. The monies received plus the pay-outs from the various pension plans have resulted in just under £173,000 overshoot on the lifetime allowance,’ she wrote in a letter to Webb.
‘My point is that the law was introduced to prevent very wealthy people from overfunding their pension plans. It seems very strange to me that I am being penalised for becoming a widow. Whilst the payments may seem large when lumped together they need to be invested wisely to ensure I have an income for the rest of my life and to potentially cover the costs of any care I may need later in life. It seems manifestly unfair that I, and I’m sure others, are treated in this way.’
Emma Lunn is a freelance personal finance journalist
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