Property passing outside the estate - Pension scheme benefits

Learning Outcomes

After reading this article, you will be able to identify when and why pension scheme death benefits pass outside a deceased’s estate, explain the legal and tax consequences, and apply the relevant rules to SQE1-style scenarios. You will understand the role of trustee discretion, the effect of nominations, and the inheritance tax treatment of pension benefits, including key distinctions based on age at death and recent case law.

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. In your revision, focus on:

• 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

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, often outside the estate. Understanding the legal structure, the effect of nominations, and the inheritance tax treatment is essential for SQE1.

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.

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.

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.

Trustee discretion and member nominations

Most modern pension schemes give trustees 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.

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.

Trustee discretion is essential. If the scheme rules require payment to the estate or a specific person, 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.

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.

Inheritance tax treatment

Where trustees have discretion, pension death benefits are not usually subject to inheritance tax as part of the deceased’s estate. However, IHT may arise in limited circumstances:

• If the member transfers pension rights or makes changes to the scheme with the intention of benefitting others and dies within two years, HMRC may treat this as a transfer of value for IHT.
• If the scheme rules require payment to the estate, the benefit is included in the estate for IHT.

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

Worked Example 1.2

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, and the member died within two years, IHT could be charged on the increase in value.

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 and timing.

Income tax on pension death benefits

The income tax treatment of pension death benefits depends on the member’s age at death:

• If the member dies before age 75, most lump sum and income payments to beneficiaries are free of income tax.
• If the member dies at or after age 75, payments to beneficiaries are taxed at the recipient’s marginal income tax rate.

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

Worked Example 1.3

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

Answer: The lump sum is paid tax-free, as the member died before age 75 and the payment is made within two years of death.

Worked Example 1.4

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 income on the recipient at their marginal rate, as the member died after age 75.

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.

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.

If the scheme gives trustees discretion, and they exercise it properly, the benefit is not part of the estate.

Recent case law: HMRC v Parry (Staveley)

The Supreme Court in HMRC v Parry & Others [2020] UKSC 35 considered whether a transfer of pension rights shortly before death was a transfer of value for IHT. The Court held that not all pension transfers are chargeable transfers for IHT. The key question is whether the transfer reduces the value of the estate and is made gratuitously.

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?

Summary Table: Pension death benefits and the estate

Key Point Checklist

This article has covered the following key knowledge points:

• Pension death benefits are usually held in trust and paid at trustee discretion, so do not form part of the estate.
• Member nominations (expression of wish) are not binding but guide trustees.
• Where trustees have discretion, benefits are not subject to IHT as part of the estate.
• If the scheme rules require payment to the estate, the benefit is included in the estate and subject to IHT.
• Income tax on pension death benefits depends on the member’s age at death: before 75, usually tax-free; after 75, taxed on the recipient.
• Transfers or changes to pension arrangements shortly before death may be treated as transfers of value for IHT if gratuitous and death occurs within two years.
• Recent case law (HMRC v Parry) confirms that not all pension transfers are chargeable for IHT; the facts and intent are critical.

Key Terms and Concepts

• pension scheme death benefit
• trust-based pension scheme
• expression of wish (pensions)
• transfer of value (IHT)
• marginal income tax rate
• estate (for succession and IHT)