The pensions freedoms introduced in April of 2015 have rightly received very broad coverage, but the changes to lump sum death benefits from pensions (LSDBs) have received less.
I have written on this blog on several occasions how many different changes we’ve seen to pensions; and we must be approaching more than two a year for the last decade.
The changes introduced from 6th April 2015 are likely to be positive for many individuals; and for most retirees will be a simplification. However choices made, particularly for those of pensionable age can affect the tax position of LSDBs, as I detail below.
Some commentators have described that the ability for invested pension funds to be cascaded down generations “free of tax” is a panacea for tax planning. This may be the case for some, but in some cases additional taxes can apply, and whilst individuals should certainly reconsider prior choices, there are still strong arguments for standalone trusts that continue after death especially where an individual is under 75.
Why ‘tax-free’ is a simplification too far
If a pensioner is under 75 the fund can generally be passed as an income, lump sum or pension fund to a survivor (not necessarily a dependent) free of income tax. However, there are two potential taxes that can still be due: a lifetime allowance recovery charge, and, in some cases, inheritance tax – there has been no change to the rules on this.
The lifetime allowance (LTA) recovery charge is most likely to occur when an individual has benefits over £1.25m, including pension life assurance plans at date of death. The rules are complex so this should be treated as a simplification and from April 2016 the limit will be £1.0m. Lump sum and money purchase (or cash balance) benefits are assessed based on the value paid out, whereas scheme pension arrangements (principally ‘defined benefit’ dependent’s pensions) are not tested against the lifetime allowance on death; but in life they are assessed against the LTA with a 20x multiple, with any lump sums added on top.
Inheritance tax (IHT) can also apply in some circumstances, most “trust‑based schemes” (modern SIPPs, Personal Pensions as well as money purchase ‘occupational schemes’) will have discretion as to whom benefits can be paid. However, the nature of the scheme should be verified, as not all schemes have discretion.
‘Retirement annuities’ and ‘Section 32’ policies (commonly known as “buyout bonds”) are contract-based rather than trust-based. Some older personal pensions may have no “master trust” exists, and maybe liable to IHT.
So what’s better: a lump sum to an individual, an inheritable pension fund, or a lump sum to a trust?
The breadth of the changes does mean that individual client circumstances, the nature of their pension provision and your objectives will mean there is no clearly preferable choice; in many cases a full reassessment and advice will be required.
Inheriting a drawdown plan would seem to be preferable from a tax perspective post-75, but thought needs to be given as to whether a dependent is still appropriate. This is because the income tax to a trust is a penal 45%, Where a pension fund is inheritance tax-free it may be preferable to pass this to nil or basic rate taxpayers, whilst offsetting other gifts (including legacies in wills) that are potentially IHT chargeable to higher or additional rate taxpayers. This can maximise the net value of legacies after inheritance and income taxes are paid.
For those who die before 75, I consider three options: lump sum to individual, inheritable fund (to spouse and other nominee), and lump sum to trust.
Lump sum to individual
Passing a lump sum to a spouse or civil partner will often be disadvantageous as the link to the pension is broken and the tax privileged status is lost.
Not all schemes will allow inheritable drawdown, and even where they do, it is actuarially quite likely the survivor goes on beyond 75, when their inherited fund would be subject to the more penal rules. However, if inheritable drawdown is permitted then it is can be an efficient option for three principal reasons:
- the fund continues to grow free of most UK taxes,
- the pension is outside of the nominated beneficiary(ies) estate for IHT, and doesn’t count towards their pensions LTA
- whilst the income from the fund is not treated as pensionable income it may allow an individual to increase their own pension contributions as they live from the fund; under current rules 25% of their new pot (not the inherited fund) can be taken tax-free in the future. Also any inherited fund remaining in the event of the death can be passed to future successors as a pension fund, potentially free of tax if the new pension holder dies under age 75
The non-tax benefit of the trust is control; not all individuals with significant pension funds relish the idea of giving their fund to children or grandchildren to spend as they wish. So as detailed above, I still believe for many trust-based pensions (most occupational and personal pensions, including self-invested personal pensions (SIPPs) and stakeholder plans) a trust will be the preferred nominated beneficiary of any LSDB, but only pre-75.
But unlike a pension, a trust is potentially exposed to income, capital gains and inheritance tax charges. It is possible, but beyond the scope of this article, to mitigate one or more of these taxes with good planning, and record-keeping. Advice around the various considerations from a tax perspective, and also the likelihood of the potential beneficiary(ies) are likely to live beyond 75.
Just because something is is technically possible scheme rules may vary and the above may not work for you. The government has stated they do not consider pensions to be an IHT avoidance tool, but these benefits cannot be ignored: the changes may make prior choices on LSDBs redundant; so now is an excellent time to be reviewing your pensions, along with nominations and trusts in the light of the new enhanced flexibilities.
This blog is necessarily complex, and we strongly recommend that you contact Alistair Cunningham who bear the cost of an initial consultation to discuss your situation and how the rules might apply to you.
