What happens to your workplace pension on death?

Steve Whiting explains what happens to a workplace pension on death and how to mitigate IHT
October 3, 2022

What happens to your workplace pension on death?

Many people with a workplace pension may not be aware of potential inheritance tax due on the funds if they die. However, there is one very simple thing you can do to ensure that the maximum amount is passed onto your beneficiaries.

What is a workplace pension?

A workplace pension is a type of pension set up by your employer to help you prepare for life after work. Some workplace pensions are called ‘occupational’, ‘works’, ‘company’ or ‘work-based’ pensions.

Under a workplace pension, a percentage of your pay is put into the pension scheme automatically every payday. In most cases, your employer also adds money into the pension scheme for you. You will also get tax relief from the government.

Some older-style or public sector pensions will be completely covered by your employer, without you having to pay in. This type of pension is not covered by this article.

Modern workplace pensions we use today began life after the 2008 Pensions Act.

In 2012, the government made it obligatory for companies of a certain size to offer a pension to their employees. It was then made mandatory for all companies in the UK to automatically enrol all eligible employees into a pension scheme in 2018.

You are an ‘eligible employee’ and will have been automatically enrolled in your employer’s workplace pension if all of the following apply to you and you have not actively opted out of the workplace pension:

  • you’re classed as a ‘worker’,
  • you’re aged between 22 and State Pension age,
  • you earn at least £10,000 per year,
  • you usually (‘ordinarily’) work in the UK.

You can normally take money out of your workplace pension when you reach 55 (57 from 2028) and most pension companies offer different ways you can do this.

However, before you take money from your workplace pension, it’s important to take professional financial advice and consult an Independent Financial Advisor (IFA). This is because when and how you take your money can make a big difference to how much tax you might pay and how long your money will last.

What happens to your workplace pension when you die

If you die before retiring (by which we mean on retirement, your pension fund would usually be used to purchase an annuity to provide you with ongoing income) the default position is that the value of the pension fund will be payable to your estate.

However, this can be problematic if adding a relatively large pot of money to your estate causes inheritance tax (IHT) to now become payable.

As workplace pensions are relatively new, little consideration appears to have been given to this fact with regards to estate planning. However, as most people’s workplace pensions grow into larger sums, then planning for what will happen to the pension funds on death will become increasingly important.

How IHT might be due on a workplace pension

IHT is a tax that falls due on death, or when gifts are made and is payable at a rate of 40% on the part of your estate that exceeds a certain threshold (currently £325,000) although this is subject to certain exemptions and reliefs.

The following example explains the potential IHT problem:

John is in a long-term relationship with his partner Joanne. Neither of them have children. He is 50 and Joanne is 45. John owns the house that he and Joanne live in mortgage free. It is worth £300,000. He also has £10,000 in savings.

John has a workplace pension which has built up to £95,000. He has already made a Will and left his estate to Joanne. His funeral costs are £5,000.

In the event of John’s death, the £95,000 pension fund will be added to his £310,000 estate, making a combined gross estate of £405,000 and a net estate of £400,000 after deducting his funeral costs.

As the combined estate exceeds the £325,000 IHT threshold, by £75,000 it will trigger an inheritance tax bill of £30,000; making a significant dent in the sum due to Joanne.

Mitigating IHT due on a workplace pension

However, an inheritance tax problem such as this, is easily avoided by taking simple steps as outlined in this article.

Most providers of workplace pensions permit the employee to name the potential beneficiary or beneficiaries of their workplace pension and this can be done in one of several ways.

So, in John’s example above, the options are as follows:

  • Do nothing and the estate is the beneficiary of the workplace pension – John can do nothing at all, meaning that the pension fund will be payable to his estate and added to the value of it, as per our example above. Before the pension fund can be released to Joanne, she would need to obtain a Grant of Probate for John’s Will in order to ratify it as his last Will and testament. Obtaining Probate can take several months, so as well as being disadvantageous from an inheritance tax perspective, this option would also delay the release of the pension fund to Joanne.
  • Name a beneficiary to receive the workplace pension – alternatively, John can nominate Joanne as the beneficiary of his workplace pension with his pension provider. This requires John to complete an online or paper form to tell the pension provider that he wishes Joanne to inherit the pension fund in the event of his death. The benefit of doing this is that the money can be paid to Joanne without waiting for the Will to go to Probate. The disadvantage is that it would, normally, still be classed as part of his estate for inheritance tax purposes.*
  • Sign a ‘Letter of wishes’ – another option is for John to complete a ‘Letter of wishes’ with his pension provider, either in paper form or online, requesting the pension provider to pay the pension fund to Joanne on his death. This will mean that the pension provider will hold the pension fund under a discretionary trust for John and his eventual beneficiary or beneficiaries. The benefits of doing this are that the money can be paid to Joanne straightaway on John’s death without waiting for Probate and that the pension fund will not normally be added to the estate for inheritance tax purposes* – saving, in our example, the £30,000 inheritance tax bill. The disadvantage is that the pension provider could, in theory, pay the pension fund to other beneficiaries who might make a claim on it. However, this is only likely to happen if there are other potential beneficiaries who were financially dependent on the person who has died immediately before his or her death.

Seek legal advice about your workplace pension now

As the value of your own workplace pension fund increases in future years it will become increasingly important to think about what will happen to it on your death, and it is worthwhile taking steps to avoid this potential inheritance tax trap now.

If you would like individual advice about what will happen to your workplace pension and other assets on your death, speak to a specialist Solicitor.

To make an appointment please contact our Wills & Probate departments at Newark, Southwell or Mansfield on 01636 671881, 01636 813411 or 01623 666700.

For financial advice, including advice on pensions, you should speak to an Independent Financial Advisor (IFA) and, if you don’t already have an IFA, we will be happy to put you in touch with one.

Alternatively, you can get free advice from Pension Wise: https://www.moneyhelper.org.uk/en/pensions-and-retirement/pension-wise/pension-pot-options.

Please bear in mind that the options described in this article are specific to workplace pensions. Other types of pensions will operate under different rules. This article is correct as at 23 September 2022. We recommend that you seek legal advice with regards to your personal circumstances before acting.

* Source Nest Pensions www.nestpensions.org.uk 19th September 2022

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