Guide The two year rule

Lump sum death benefits

Since 6 April 2015, any payment of a lump sum death benefit made after the end of a two year period, which starts on the earliest of:

• the date the scheme administrator was first notified of the member’s death, or
  
• the date that the scheme administrator could first reasonably have been expected to know of the member’s death

is still classed as an uncrystallised funds lump sum death benefit but will be taxable.

Payment of a lump sum death benefit outside of the two year period where the member died before age 75, since 6 April 2016, is taxed depending on who the recipient is.

If it is paid to someone in an individual capacity the lump sum will be taxed as pension income on that individual at their marginal rate.

If it is paid to a ‘non-qualifying person’ (see ‘Non-qualifying persons’ for more information) the payment is not treated as their income for tax purposes. Instead the scheme administrator is liable for the Special Lump Sum Death Benefit Charge at 45%, which they will normally deduct before paying the lump sum death benefit.

Beneficiary’s flexi-access drawdown

On a member’s death before age 75, a beneficiary’s income payments will be tax-free if the funds are designated into drawdown within two years starting from the earliest of:

• the date the scheme administrator was first notified of the member’s death, or
  
• the date that the scheme administrator could first reasonably have been expected to know of the member’s death

Designation into drawdown outside of the two year period will mean that any income payments taken will be taxable at the beneficiary’s marginal rate.  

If a beneficiary designates funds into drawdown following the death of a member aged 75 or over, any income payments they take will be taxable at the beneficiary’s marginal rate. This is the case irrespective of how long it takes to designate funds into drawdown following the member’s death.

Beneficiary’s annuity

If an individual dies on or after 3 December 2014 and before the age of 75 with uncrystallised funds remaining, any payment of a dependant’s or nominee’s annuity bought with these funds will be paid tax-free, if:

• the entitlement to the beneficiary’s annuity arose within two years of the date the scheme administrator was first notified of the member’s death or the date the scheme administrator could first have reasonably been expected to know of the member’s death (‘the two year period’), if earlier, and
• the first payment is made on or after 6 April 2015. 
  

If the beneficiary becomes entitled to the annuity outside of the two year period, the full annuity payment will be taxable at the recipient’s marginal rate, even if some of it is bought with unused drawdown funds belonging to the deceased member (an annuity bought with unused drawdown funds only is not subject to the two year rule and therefore would be paid tax free if the other conditions are met).

Note – payments from a successor’s annuity will be tax free if all of the conditions below are met:

• it is paid in respect of a deceased member of a registered pension scheme (regardless of the member’s age at the date of death)
  
• it’s paid on the subsequent death of a dependant, nominee or preceding successor of the member (the beneficiary)
  
• the beneficiary in respect of whom it’s paid died before age 75, on or after 3 December 2014
• the annuity is bought with undrawn funds
• the first payment is made on or after 6 April 2015

The two year rule doesn’t apply to successors annuities.

Since 6 April 2016, any payment of a drawdown lump sum death benefit after the end of the two year period, starting on the earliest of:

• the date the scheme administrator was first notified of the member’s or beneficiary’s death, or
• the date the scheme administrator could first have reasonably been expected to know of the member’s or beneficiary’s death
  

will be taxed depending on who the recipient is, where the member or beneficiary dies before age 75.

If it is paid to someone in an individual capacity the lump sum will be taxed as pension income on that individual at their marginal rate. In most cases, the provider won’t have the individual’s tax code to operate against the payment and will need to deduct income tax using an emergency tax code. This will usually result in too much tax being deducted, but the recipient should be able to reclaim any overpaid tax. More information on this can be found on the Government website.

If it is paid to a ‘non-qualifying person’ (see ‘Non-qualifying persons’ on the next page for more information) the payment is not treated as their income for tax purposes. Instead the scheme administrator is liable for the Special Lump Sum Death Benefit Charge at 45%, which they will normally deduct before paying the lump sum death benefit.

This means that lump sum death benefits paid from drawdown funds where the member, dependant, nominee or successor died before age 75 will only be tax free if it’s paid within this two year period.