What happens to unused tax-free cash in my pension?

Q: What happens to unused tax-free cash in my pension if my spouse inherits my estate and dies before 75? What happens after 75?

A: This is a really important estate planning question. The tax treatment rules depend on your age at death and whether the pension is defined contribution (DC) or defined benefit (DB). I’ll assume you’re asking about a typical defined contribution pension (Self-invested Personal Pension or workplace pension pot) in this scenario.

First, what is ‘tax-free cash’?

Typically, you’re able to take up to 25% of your pension pot tax-free (up to certain limits). You can choose to take the whole amount as a single lump sum or in smaller amounts over time. The process of accessing your pension in this way is called ‘crystallising’ your pension.

If you die before taking some or all of this 25%, it doesn’t automatically disappear - but how it’s treated next depends on your age at death.

It’s worth noting that there is now a limit called the Lump Sum Death Benefit Allowance (LSDBA). This is effectively a cap (currently £1,073,100) on the total amount of pension death benefits that can be paid out as tax-free lump sums. It excludes any pension fund that was crystallised before 6 April 2024.

Any lump sum paid to beneficiaries above this allowance may be subject to income tax, so for larger pension pots this can affect how much remains tax-efficient to pass on.

Passing to a beneficiary

An Expression of Wish form lets you choose who you would prefer your pension savings to go to and in what proportions.

Pension benefits are usually held under trust and do not form part of your estate, so they are not normally distributed according to your will. Instead, the scheme administrators or trustees decide who receives any remaining funds, taking your Expression of Wish into account.

To pass it to your spouse, it’s best to nominate them as a beneficiary through an Expression of Wish form. While the pension administrators are not obliged to follow the preferences stated in the form, they do take them into account in most cases.

Generally, it’s good practice to review your Expression of Wish form every three years to check you’re still comfortable with who you’ve nominated as your pension beneficiaries. It’s also advisable to update your Expression of Wish whenever you make changes to your will (or when you create a will if you haven’t already), to keep everything aligned.

If you die before age 75

This scenario is more favourable from a tax perspective.

If you pass away before you turn 75, your pension can usually be passed to your spouse free of income tax. This includes any remaining tax-free cash in the pension pot.

They can take the funds as a tax-free lump sum (which will be tested against the original member’s Lump Sum Death Benefit Allowance). They can also move it into a ‘beneficiary drawdown’ account or take an annuity tax-free, provided benefits are paid within two years of the scheme being notified of death. A beneficiary’s annuity can be purchased at any age.

It’s worth noting that while tax-free lump sums are tested against the original member’s LSDBA, withdrawals from beneficiary drawdown or an annuity can be taken tax-free for the beneficiary’s lifetime.

If you die after age 75

If you pass away after 75, your spouse can still inherit your pension, but withdrawals are taxed at their marginal income tax rate. If you hadn’t taken your full 25% tax-free lump sum before death, it doesn’t become available tax-free to your spouse. Instead, whatever they withdraw is taxed as income.

For this reason, you may want to consider any remaining tax-free cash as you approach age 75. If you haven’t fully taken your tax-free cash, doing so before age 75 can help ensure it remains income tax-free for your spouse and/or beneficiaries

What happens to the pension when your spouse passes away?

If your spouse has inherited your pension pot, chosen not to take all the money from the pension, and they then pass away, the tax treatment again depends on their age at death.

The following assumes your spouse has completed an Expression of Wish form nominating a beneficiary:

• If they die before age 75 - any remaining funds can usually be passed to the next beneficiary tax-free. This beneficiary has the option to take the funds either as a tax-free lump sum, move them into a ‘successors drawdown’ account or take an annuity tax-free. This is again provided benefits are paid within two years of the scheme being notified of your spouse’s death. If the money is taken as a tax-free lump sum, it will be tested against the deceased member’s (your spouse’s) Lump Sum Death Benefit Allowance, whereas withdrawals from beneficiary drawdown or an annuity will not be.
• If they die after age 75 - if your spouse passes away after 75, the next beneficiary can still inherit the pension, but withdrawals are taxed at the beneficiary’s marginal income tax rate.

This effectively could continue each time the pension is passed on, with the same age 75 rules applying for each new beneficiary.

What about IHT?

Currently, pensions are exempt from inheritance tax (IHT), however from 6 April 2027, inheritance tax is expected to apply to most unused pension funds and some death benefits. This represents a significant change, as pensions have traditionally been an efficient way to pass on wealth, particularly where death occurs before age 75. So even though a pension can still be passed on free of income tax if the member dies, it may now be subject to IHT.

This makes it even more important to review your pension. Checking that your plans for passing on your pension still align with your estate planning goals, and that your beneficiary nominations are up to date, are good places to start. To update an existing beneficiary you can simply log in to your account and navigate to Profile>Pension Setting>Add Beneficiaries or you can use the Expression of Wish application form to nominate beneficiaries.

The Government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944.

Our retirement specialists can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.

Got a burning question you want to ask? Why not drop us a line. Click here to ask your question.

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• Read: 3 admin hacks to cut tax when you die
• Read: 5 money mistakes people make in their 70s

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). Tax treatment depends on individual circumstances and all tax rules may change in the future. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.