UK autumn Budget changes: two year death benefit rule and serious ill-health lump sums

Two year rule change

When a registered pension scheme member dies before age 75, many death benefits are tax-free only if they are paid out, or the funds are designated, within two years. This two year window starts to run from the date the scheme administrator for tax purposes first knew, or could reasonably have been expected to know, of the member’s death. If that window is missed, the benefit is automatically subject to income tax. (Other taxes can sometimes apply for different reasons even if the deadline is met.)

We have seen many examples of the two year deadline being missed, for example, where potential recipients of death benefits are hard to track down, where there are conflicting claims from potential beneficiaries which are not easily resolved or due to administrative challenges. Payment outside the two year window can result in a material tax charge for the recipient(s), even where the delay was outside their control. It can also cause trustees to be put under significant time pressure as the deadline approaches. 

The Budget document says the government is removing the two year rule so that beneficiaries will no longer be taxable solely because pension and lump sum death benefits are paid more than two years after the member’s death. The government says this change will apply to any payments made on or after 28 October 2026 and will be introduced in the forthcoming Finance Bill 2026-27. A HMRC policy paper sets out some more details on the measure and the policy costings document clarifies that this change applies regardless of when the member died.

Trustees and providers should take note of the government’s announcement and liaise with their administrators about updating death benefit processes to reflect the removal of the two year rule.

They should also check scheme rules to ensure they do not “hardwire” the two year rule, or have automatic consequences flowing from two years. Any provisions like this may mean trustees are then restricted in their options for payment of the benefits, so rule amendments should be considered.

Death benefit payments already made before 28 October 2026 where the two year limit was breached do not appear to benefit from this easement, and tax is still likely to be payable. There may, however, be some scope for debate in relation to payments initiated just before that date. 

The changes give schemes and administrators some breathing space where cases become protracted but it will of course still be important for trustees to action death benefit payments as soon as practicable. Payments that are unnecessarily delayed can still be subject to maladministration claims even if they are within the two years, and that will not change. 

The forthcoming changes to the inheritance tax (IHT) regime from April 2027 will make prompt handling of death benefits even more important, as interest will start to accrue on any IHT due on benefits payable from pension schemes six months after the month when the member died.

A member of a registered pension scheme may commute their pension for a SILS where they are terminally ill and have a life expectancy of less than a year.  If the member is under age 75, the lump sum can generally be paid tax-free (provided it is within the member's available lump sum and death benefit allowance). 

To qualify for a SILS, certain conditions must currently be met under the Finance Act 2004. These include that before the SILS is paid the scheme administrator has received evidence from a registered medical practitioner that the member is expected to live for less than a year. It can be challenging to get appropriate evidence quickly when a member is very ill and may not have long to live.

The Budget document says the government will change the definition of terminal illness to make it easier for terminally ill people to access their pension savings and to allow for overseas registered medical practitioners to provide medical evidence. Press reports suggest the idea is that the pensions tax definition should align more closely with the slightly more flexible definition used by the DWP for certain state benefits linked to terminal illness, to reduce administrative hurdles. 

We have not yet seen the details but the Budget overview says the government will allow a SILS to be paid where the member “can be reasonably expected to live” for less than a year (as opposed to the current Finance Act 2004 condition which says the member “is expected to live” for less than a year). We understand that clarification will also be provided that a medical practitioner based outside the UK may provide medical evidence of a terminal diagnosis if the member is living in the country where the practitioner practises medicine. The changes are due to be included in the Finance Bill 2026-27.

Trustees and providers should check scheme rules to ensure they do not hardcode the current requirements. If they do, rule amendments may be advisable.

SILS applications (by their nature) need to be addressed quickly. So, once the new rules are confirmed, changes will need to be made promptly to scheme processes concerning the payment of SILS.

Given all of the current and upcoming pensions developments, a Budget without seismic pensions changes was welcome. 

The government’s policy paper says the two year rule abolition should make the tax system fairer and administratively less burdensome. We agree. We have seen this time limit cause significant issues in circumstances where the neither the scheme nor the beneficiary (often a deceased member’s grieving relative) had control over a delay.

Interestingly, government projections suggest this change will lead to a £15m a year reduction in tax revenue from 2027/28 onwards. This gives some indication of the previous tax impact of missing the two year window. This also calls to mind the proposed six month time limit for payment under the new pensions IHT rules from next April. Could this eventually lead to similar (if not more severe) issues?

We have not yet seen the full details of the planned changes to the SILS conditions but the proposals  would appear to bring a modest (but potentially helpful) element of additional flexibility into this emotive area. Anything that could help to speed up the payment of SILS for terminally ill members is surely good news. Unlike the two year rule, this is not an immediate change but we expect that it may come into force as soon as next year, potentially in April 2027. 

Note that, in addition to the changes discussed above, some other technical pensions tax changes are also described in Budget documents. These include amendments to the way tax is assessed and collected where a deceased member’s lump sum and death benefit allowance has been exceeded, updates regarding the inheritance tax treatment of liabilities relating to property held in trust and changes to help facilitate DC scheme consolidation and retirement Collective DC.  

In the case of DC consolidation, this is expected to include expanding the circumstances in which a member can retain certain protections following a transfer. As this can sometimes be a blocker on transfers, further detail is keenly awaited.