Chancellor John Healey. Kirsty O'Connor / No 10 Downing Street
The government will remove the two-year rule so that beneficiaries will no longer be taxable solely because tax-free pension and lump sum death benefits are paid more than two years after the member’s death.
The Budget document today (28 October) said the change will apply to any pension and lump sum death benefit payments made on or after 28 October 2026, regardless of when the member died, and will be introduced through Finance Bill 2026-27.
It said the move would cost around £5m in the 2026-27 tax year and then £15m a year thereafter.
The government also confirmed it will make changes to the way tax is assessed and collected where a deceased member's lump sum death benefit allowance has been exceeded to provide greater certainty to individual beneficiaries.
The move comes after Cabinet Office minister Sally Jameson said that beneficiaries would not be left out of pocket should Civil Service Pension Scheme (CSPS) delays lead to avoidable death benefit tax charges.
Earlier this month, the chair of the influential House of Commons Public Accounts Committee Sir Geoffrey Clifton-Brown said it was with "disbelief" he learned the pension benefit payments for families of deceased civil servants could be taxed due to administrative delays at the scheme.
Under current rules, where a person dies under the age of 75, their heirs generally receive lump sums and other payments free of income tax as long as these lump sums are paid within two years of the notification of the death. If payment takes longer than this, income tax must be paid at the recipient's marginal tax rate.
Responding to the Budget announcement, Clifton-Brown said: "This is a welcome announcement from government that I hope will go some way to reassuring civil service members caught up in an avoidable crisis that should never have escalated to this degree. This announcement is not to absolve Capita from processing and making payments to members of this scheme in a timely manner. Our committee will continue to scrutinise this ongoing crisis and its impact closely."
Reaction
LCP said removing the two-year rule on lump sum death benefits was a "welcome simplification" - noting that doing so with immediate effect today would be a great relief for any dependants facing an imminent tax bill.
Despite this, the consultant said there were relatively few cases caught by this rule - adding that, in its experience, the rule affected no more than 1% of lump sums payable on death.
LCP principal Tim Camfield commented: "This very welcome new flexibility in the area of income tax is in sharp contrast to the April 2027 application of inheritance tax (IHT) to pensions. Under IHT rules, there's a far shorter 6-month deadline before 7.75% interest plus penalties can apply.
"Trustees, pensions administrators and HMRC systems, as well as executors and beneficiaries, are going to need to be extremely on the ball and work closely in tandem to avoid these IHT charges."
Broadstone head of policy David Brooks agreed: "Among the more technical pensions measures announced in the Budget, the removal of the long-standing two-year rule for death benefits is particularly welcome. Under the existing framework, beneficiaries could face different tax outcomes simply because it took longer than two years to identify beneficiaries, resolve disputes or complete the administration of a death benefit case. Removing that cliff edge should mean outcomes are driven more by member circumstances and less by administrative timetables.
"Notwithstanding the wider changes to the inheritance tax treatment of pensions, this is one of those reforms that should be welcomed on its own merits. Death benefit cases are often among the most sensitive and complex matters schemes deal with, and the previous rules could produce outcomes that felt difficult to justify where delays arose through no fault of the beneficiaries involved. The change is therefore a rare example of a reform that appears to improve both fairness and administrative simplicity, and is likely to be warmly received by trustees, administrators and members alike."
