Death-in-service: a perk that's carved in stone

Simon Hildrey looks at a benefit that can protect dependants

Nobody likes to contemplate their own death but it can be financially advantageous to think the unthinkable.

Nobody likes to contemplate their own death but it can be financially advantageous to think the unthinkable.

Thanks to soaring house prices and the closing of loopholes by the Chancellor, Gordon Brown, the question of how to minimise inheritance tax (IHT) has begun to loom large in the minds of savers.

But there is another posthumous payout that is often overlooked in financial planning: death-in-service benefit.

Many employees have such a benefit linked to either their pension or to a separate insurance scheme set up by their company. If they die before retirement, up to four times their annual wage - up to a salary limit of £102,000 from 6 April - will be paid out in a tax-free lump sum to their nominated beneficiary.

Adrian Shandley, director of independent financial adviser (IFA) Premier Wealth Management, says it is crucial to remember that death-in-service benefit is separate from your will. He cites the example of a client who struggled through a difficult divorce, redrafting his will to exclude his former wife. However, he forgot to change her name on his death-in-service benefit form. Mr Shandley's client died before reaching retirement, and his ex-wife received the tax-free lump sum.

"Keep the nominated beneficiaries up to date," he warns. "And don't forget that additional voluntary contribution schemes [AVCs] are also subject to the same rules."

Technically, the decision on who is to receive the lump-sum payment is at the discretion of the trustees of the death-in-service benefit scheme. In theory, says Rebekah Haymes, corporate risk and healthcare manager at IFA Charcol Holden Meehan, trustees can decide not to pay out to a nominated beneficiary.

For example, if a distant relative or charity were nominated instead of a spouse or children, the trustees could decide to pay the latter instead. However, this rarely happens, says Ms Haymes.

Under the terms of death-in-service payout schemes, a nominated guardian is required to look after the money until the beneficiary reaches the age of 18. This can present a particularly tricky problem if, say, a policyholder with a young son or daughter named on the paperwork dies after a messy divorce.

In one case involving an estranged couple, the ex-husband no longer had anything to do with his wife or 16-year-old daughter. But when the woman died, having requested that her daughter receive the death-in-service benefit, the trustees - who had no idea of the family's situation - passed the payout to the former husband as the girl's nominated guardian.

Updating your death-in-service benefit policy may not be top of your list of priorities during times of personal crisis. But one way to make sure the money doesn't fall into the wrong hands is to write your death-in-service benefits policy under a flexible trust, says Bob Dimond, senior account manager at IFA Advisory & Brokerage. The trustees will then pay the benefits in accordance with your "letter of wishes".

Anne Young, senior technical manager at insurer Scottish Widows, says a flexible trust can also help in IHT planning. If you ask for your death-in-service benefit to be paid to the trust, instead of leaving it directly to your spouse, the money will stay outside your spouse's estate for IHT purposes.

After your death, your spouse can receive capital and income from the trust. Further reductions in IHT liability can be achieved, says Ms Young, if the trust can make loans to beneficiaries, such as the spouse, children and grandchildren. The loan reduces the size of the estate handed on by the surviving spouse to his or her family.

But for those in company pension schemes, tax planning is not so easy. Occupational death-in-service benefit schemes are in so-called "master" trusts and cannot be written under trust by policyholders. However, by agreement with your employer, you may still be able to establish a flexible trust and ask the trustees of the corporate pension scheme to pay the benefits into the trust.

Separately, if you have an individual personal pension that pre-dates 1987 - known as "section 226" retirement and annuity contracts - it's worth checking the terms of the death-in-service benefit.

Instead of automatically releasing a lump sum on your death, some of these older contracts pay out premiums and interest instead.

"If you find that you have a section 226 policy and have to yet to retire, you might want to consider switching to a [newer] personal pension as [these] will pay out the full fund value in a tax-free lump sum," says Mr Shandley at Premier Wealth.

But check first for any penalty transfer fees that could make a big dent in your pension pot.