We often meet homeowners who worry about how retirement savings will pass on after death. Our aim is to set the scene in plain English and help you weigh control against simplicity.
We explain what it means when someone considers leaving their retirement fund into a discretionary trust. We show the trade-offs: trustees can protect assets and guide beneficiaries, but keeping funds inside the pension wrapper often gives better tax treatment and less admin.
This matters most for blended families, second marriages and those with vulnerable beneficiaries. It also matters when there are risks from divorce, creditors or care-cost assessments.
We preview the key tax points you must know: income tax on death benefits, inheritance tax if money moves into trust, and the cost of investing outside the pension. By the end, you will know what to ask your provider, IFA or solicitor and when to seek professional advice.
Key Takeaways
- Control vs simplicity: trusts give control; pensions often give simpler, tax-efficient outcomes.
- Who it helps: useful for blended families and vulnerable beneficiaries.
- Tax matters: check income tax on death benefits and any inheritance tax risk.
- Practical checks: confirm whether your scheme will pay into a trust and how death age affects tax.
- Get advice: ask your provider, IFA or solicitor before making changes.
What a bypass arrangement is and how it works in practice
A bypass arrangement channels lump-sum death payments into trustees’ hands rather than straight to family.
We define a bypass arrangement as a small discretionary trust set up in life. Its main purpose is to receive lump-sum death benefits through a nomination or expression of wish.
Typically, you create the trust with a nominal gift—often £10—then complete the provider’s form asking the scheme to consider paying the death benefits into that trust. The scheme administrators and trustees still must exercise discretion when making any payment.
Many schemes treat your nomination as guidance. That means even with the correct form, the scheme may pay the estate or a named person if it has no discretion.
Quick checklist for your provider
- Does the scheme accept trust nominations or only binding forms?
- Will scheme administrators follow your expression of wish?
- What wording do trustees require for an effective transfer of value?
Why people consider leaving pension to a discretionary trust uk
It’s common to want to protect family wealth while still providing for a surviving partner.
Many clients ask how to keep control of retirement funds for their children or grandchildren. They worry a surviving spouse might later nominate new heirs and the money could drift away.
Trustees can hold funds and decide who benefits, when, and how much. That helps in blended families where bloodline wishes matter.
Trustees also protect young or vulnerable beneficiaries. They can make staged payments, fund education over time, or provide loans repayable to the settlement. This reduces the risk of a single lump sum being misspent or claimed in divorce.
There are practical gains and costs. Holding money in a settlement can shelter it from some care means tests and family law claims, but it does add administration, tax returns and trustee fees.
For a step-by-step guide on how to set one up and what to expect, see our short guide to start a trust fund.
Your main alternatives: nominee drawdown, successor nominations and direct lump sums
Choosing between drawdown, successor rules and direct lump sums shapes how value flows after death. We set out the three routes families use and the practical trade-offs.
Nominee / dependant drawdown: the beneficiary keeps the fund inside the scheme and draws income over time. That usually preserves CGT relief and lets beneficiaries manage income tax bands.
Successor nominations: the first recipient often becomes the decision-maker later. That can mean your original intentions fade if the spouse or nominee chooses different heirs.
Direct lump sums: cash paid straight into an estate is simple and quick. It suits small pots or when heirs need immediate funds, but it may trigger income tax or inheritance tax consequences.
“Keeping money in the wrapper often gives better tax treatment while trusts buy control at a cost.”
Decision snapshot: if you want simplicity and probable tax efficiency, drawdown usually wins. If intergenerational control matters most, consider the extra structure. For more on bypass arrangements see bypass trusts.
Income tax on pension death benefits paid to a discretionary trust
The tax picture on post-death payments is the single biggest practical issue trustees will face. We break the rules down so you can see the likely outcome for beneficiaries.
Death before age 75 and the LSDBA
If death occurs before 75 and the scheme pays within the two-year relevant period, lump sum death benefits are normally paid gross. They are tax-free up to the member’s available lump sum allowance (LSDBA).
Any amount above that allowance is taxed as pension income in the hands of the trustees or beneficiary.
The two-year relevant period
Scheme administrators must normally pay within two years of becoming reasonably aware of the death. Delays can change the whole tax result.
Death after age 75 and the 45% charge
Where death happens after 75, lump sums paid into a settlement usually face a 45% special lump sum tax charge on the whole amount before trustees receive funds.
Reclaiming tax when distributions reach beneficiaries
When trustees later pass money to an individual, that payment is treated as the recipient’s income with a 45% tax credit under FA 2004 s206.
Beneficiaries can reclaim overpaid tax through Self Assessment or by using form R40 if they do not file returns. Scheme administrators must state gross and tax within 30 days, and trustees must give the same breakdown to beneficiaries within 30 days of payment.
“Clear, timely figures from scheme administrators and trustees make a reclaim straightforward for beneficiaries.”
For practical steps on minimising wider liabilities, see our guide on avoid inheritance tax on pensions.
Inheritance tax and relevant property charges: what trustees may face over time
When death benefits move out of the pension wrapper and into a settlement, the long‑term IHT picture changes.
How pensions can become relevant property
Pension arrangements can be treated as settlements for inheritance tax under IHTA 1984 s43(2). While benefits remain inside a scheme they often enjoy special exemptions. Those exemptions can stop applying once money is paid into a discretionary settlement.
Periodic and exit charges trustees must watch
Once death benefits are held in relevant property, trustees face two main IHT-style charges.
- Periodic charges: levied at ten‑year points, calculated on the value retained. These can erode capital over time.
- Exit charges: apply when capital leaves the settlement and are based on the proportional liability since the last charge.
Ten‑year anniversaries and scheme join dates
Crucially, the reference date for a ten‑year charge can link back to when the member joined a trust‑based scheme, not just when trustees received funds. That quirky rule can move an anniversary earlier and change charge calculations.
Multiple arrangements, multiple nil‑rate bands
Having several schemes may create separate settlements and separate nil‑rate bands. Consolidation can reduce the number of settlements and so alter how many nil‑rate bands apply. Trustees must check historic transfers and start dates before acting.
| Issue | What trustees should gather | Practical effect |
|---|---|---|
| Start dates | Dates when each scheme was joined or transferred | Determines ten‑year anniversaries and periodic charge timing |
| Scheme type | Whether each arrangement was trust‑based or contract‑based | Affects whether separate settlements exist and how nil‑rate bands apply |
| Historic transfers | Records of any consolidation or value transfers between schemes | Can change settlement count and IHT liability calculations |
| Payment timing | Dates when death benefits were paid out of the scheme | Two‑year payment windows can affect exemption status |
“Treat the paper trail as vital: poor records can raise liability and professional costs.”
Before you act, gather scheme start dates, transfer history and provider paperwork. For guidance on practical estate steps and protections, see our resource on secure your family’s future.
Ongoing tax and costs once money leaves the pension wrapper
Once benefit payments move outside the pension wrapper, the ongoing costs and tax rules change in ways many families miss.
Income tax on investment returns is charged at trust rates. Trustees pay higher rates than many individuals, and that tax can reduce the cash available for beneficiaries.
Trustee income tax and the tax pool
When trustees pay tax on interest or dividends, that tax forms a tax pool. It gives beneficiaries a credit when income is distributed, so some tax can be reclaimed.
However, reclaiming needs clear records and timely statements. Without these, beneficiaries face extra work and possible delays on reclaiming tax relief.
Capital gains and reduced allowances
Capital gains on sold investments are taxed with a smaller annual exempt amount than for individuals. That means sales to raise cash can trigger noticeable taxation.
This raises the fund’s overall tax liabilities and can erode value faster than expected.
Administration and ongoing fees
Expect annual accounts, HMRC reporting and beneficiary statements. Professional trustee and accountancy fees add up.
- Record keeping and annual returns
- Trustee fees and solicitor support
- Accountant costs for tax filings
“For smaller pots, nominee drawdown may deliver the same outcome with less tax and admin.”
For proposed changes that may affect taxation of unused retirement funds, see the government note on inheritance tax on unused pension funds and death.
How the rules may change: pension IHT reforms expected from April 2027
New rules due in April 2027 could reshape how retirement pots are treated for estate tax.
What the government proposes: unspent defined contribution savings may count as part of the deceased’s estate for inheritance tax. This removes the long‑standing separation between those savings and estate value.
Double exposure risk
Practical effect: the same money could face IHT at 40% and then income tax when beneficiaries withdraw funds. That scenario increases overall tax liabilities and can halve the net amount available.
Knock‑on housing impact
Including pension value in estate totals may push households over the £2 million threshold. That can reduce the residence nil‑rate band under the taper rules and raise IHT further.
What we suggest you review now
- Confirm beneficiary nominations and update where required.
- Check spouse transfers; these remain IHT‑exempt and may preserve value.
- Review drawdown strategy so income timing fits family needs and tax timing.
| Issue | Immediate action | Why it matters |
|---|---|---|
| Nomination forms | Verify provider records and update annually | Ensures intended beneficiary treatment if rules change |
| Spouse transfers | Assess if transfer of rights is appropriate | Preserves exemption from IHT for many estates |
| Drawdown timing | Model withdrawals for tax efficiency | Reduces chance of double taxation on the same value |
“These measures remain proposals. Start planning now, but seek tailored advice before making irreversible changes.”
Conclusion
Choosing the right route for death benefits means weighing certainty against complexity.
A bypass arrangement can buy control. It often suits blended families, clear bloodline wishes, vulnerable heirs and cases where staged support or repayable loans are needed.
However, this control can bring immediate tax on lump sums, possible relevant property IHT charges, and ongoing admin and tax filings. After age 75, the special 45% lump sum charge is a major risk.
For simpler households, smaller pots or where tax efficiency matters more, keeping funds inside drawdown usually works better.
Next steps: confirm scheme discretion, update nominations, review wills and speak with a regulated adviser or solicitor experienced with trust planning. For guidance on nil‑rate band options see nil-rate-band discretionary trust.
We aim to protect not just tax outcomes but clarity for your family when death benefits are paid.