It is no longer the case that a pension has to “die with you”. From 6 April next year many more people will simply have pension savings from which they can draw down what they want, when they want, from age 55. People may not spend all of their pension savings, and the prospect of unspent funds means there is wealth capable of being inherited.
The chancellor’s announcement last month about the proposed scrapping of the 55 per cent pension death tax also creates more choice for clients about who can inherit their pension and how, with less tax to pay – a combination that is likely to get clients interested. Research shows that being able to leave any unused pension funds to their loved ones is a priority for people – 71 per cent said that was a very important consideration. The changes to how pensions are taxed when they are passed on will spark more interest in saving into a pension as a ‘family savings pot’ – an opportunity for advisers to make the most of with their clients.
At the moment, when it comes to defined contribution pensions, it is often the case that the surviving spouse or civil partner (or dependant) takes drawdown in preference to paying the 55 per cent tax charge on a lump sum.
But as more and more of the ‘Sipp generation’ moves into drawdown, it is time to think about the prospect not just of the original Sipp client taking drawdown, or even the surviving spouse or civil partner then taking drawdown. In larger cases, there could be unspent pension savings available to support a third family member, who then takes drawdown many years later. And as usual with modern pensions, the value is generally outside the estate of the client for inheritance tax purposes, other than any withdrawals made and not spent.
Flexible access to pensions from 6 April 2015 is not just about how today’s clients can access their pension savings – it is about how their loved ones can access them in future too.
Today, a 55 per cent tax charge applies in two pension situations when someone dies:
1. Where someone dies under the age of 75, and had started to take money out of their pension (that is, was in income drawdown), a 55 per cent tax charge applies if a lump sum is paid out.
2. Where someone dies aged 75+, their pension fund is taxed at 55 per cent when a lump sum is paid out, regardless of whether that person had taken any withdrawals or not from their pension savings.
The chancellor’s proposals scrap this approach, and replace it with an alternative linked to the age of 75:
1. There would be no tax to pay on an inherited pension fund where someone dies before age 75. This means the beneficiary could take a lump sum, or take drawdown, tax-free. In the past, this lump sum might have been taxed at 55 per cent – so 55 per cent to zero per cent would be a big reduction. Many families could benefit from this, even if there is only a small pension fund, leading to more money to support them after their loved one has died.
2. Where someone dies after age 75, the rate of tax due on the pension fund would depend on the income tax position of the person inheriting the pension, unless a beneficiary takes a lump sum. The normal income tax rates of zero per cent, 20 per cent, 40 per cent or 45 per cent would apply to money drawn down from the inherited pension, depending on what income the recipient had. If taken as a lump sum, a 45 per cent tax rate would apply.
The tax-free outcome for the loved ones of someone who dies before the age of 75 is not universal. It does not apply to income from annuities or scheme pensions, where a beneficiary will pay income tax at their marginal rate. DC pensions are the main winners with these changes.
A client’s will does not normally control who inherits their pension (with a few exceptions) – this is usually done through a Beneficiary Nomination form provided by the pension company. A key action for clients in light of the new rules will be to keep this Beneficiary Nomination form up-to-date.
It is good news that there is much more flexibility about who can inherit a pension under the new rules. I will be happy to see the back of the limited concept of ‘dependant’ in terms of flexible pensions, which narrowed who might take an income. ONS statistics show there were 7.7m one person households in 2013. For some people, friends are more important than relations, who only feature on a family tree. Freedom to choose your beneficiary will be much valued.
For clients who have built up very large pension pots of their own, the good news is that any inherited pension they receive under these rules does not count towards their own pension savings limit. (From 6 April this year, the lifetime allowance reduced to £1.25m).
If a client dies before the new rules come in, it is possible that the new rules could still apply to the pension death benefits. That is because it is the date of payment which counts, not the date someone passed away. It can take some time for arrangements to be made, and pension administrators often have discretion over when payments are made. If your client is in this situation, get in touch with the pension company to discuss the options.
There is still a lot of detail to be finalised and a consultation process is underway, to enable the new rules to apply with the rest of the pension reforms on 6 April 2015. The measures which enhance inheritable pensions are a logical extension of flexible access for the original client. The pension is then just rolled forward and rolled forward as the pension savings pass from beneficiary to beneficiary, until they are fully spent.
Pensions will become family savings plans that not only support the original client in retirement, but also enable one generation to support the next and beyond.
Julie Hutchison is an estate planning expert for Standard Life