At the Conservative party conference on 29 September, George Osborne announced that regardless of the date of death, where payment of death benefits is delayed until April 2015:
• Death benefits pre-75 would be free of tax, either by lump sum (55 per cent tax rate now if in drawdown on death or nil if uncrystallised) or by inherited drawdown (previously this was only available to dependants and taxed at the dependant’s marginal rate of income tax).
• On death after age 75, income taken from inherited drawdown, including as single or multiple lump sums, would be taxed at the beneficiary’s marginal rate.
• On death after 75 where benefits are paid as a lump sum outside a pension they will be taxed at the dependant’s marginal income tax rate following a transitional period where a 45 per cent tax rate applies until April 2016. This includes value protection from annuities.
In effect the treatment of lump sum death benefits and taxable income has been equalised between drawdown and uncrystallised funds. In both cases, an inherited drawdown will no longer simply apply to dependants but to any beneficiary.
Death benefits from annuities remain taxed at the beneficiary’s marginal rate of income tax, unless paid as an annuity protection lump sum, commonly known as value protection.
This announcement came rather out of the blue; most commentators were instead expecting a new 40 per cent death benefit tax on crystallised pensions to be announced in the Autumn Statement on 3 December. However, these changes have been deemed necessary to support the pension freedoms first announced in this year’s Budget.
What this means
Until now, the proposed April 2015 rules looked as if there would be a greater emphasis on preservation of death benefits. By taking benefits under phased drawdown – that is, drawing benefits by part tax-free cash and part income – retirees could protect more death benefits while not losing any income flexibility.
The decision to remove tax on death benefits below the age of 75 means that phased planning to protect pension death benefits is no longer required. This should also reduce the burden on scheme administrators.
At a broader level, this change also removes the main technical impediment to drawing benefits and clients can now be encouraged to take tax-free cash should they need it.
Meanwhile defined contribution pensions now become increasingly – but still not fully – inheritable post-75. There will still be some tax but it will potentially be lower. The age 75 change has garnered fewer headlines but will probably have a bigger effect.
How planning might change
In effect, this change should simplify advice before the age of 75 by removing the need for phasing benefits, but it is likely to change the focus of income drawing after age 75.
Now death taxes on drawdown pensions are zero until 75, and marginal rates beyond that age, income drawdown has been put at an advantage to annuities in terms of death taxes. This is not quite another nail in the annuity coffin, but another reason to consider choice of retirement income products carefully. Income drawdown will continue to increase in popularity and planners must ensure the longer term longevity risks, previously managed by an annuity, are dealt with.
From an estate planning perspective, previously it made sense to use drawdown and spend pension assets (subject to 55 per cent tax on death) as opposed to non-pension assets (subject to a maximum of 40 per cent on death). But a wholesale reversal of this strategy may now be sensible.
We may even see people funding their pensions specifically for estate planning and going beyond the tax relieved contributions – they could fund a pension after age 75 knowing they won’t get tax relief. Their motivation is that they favour their dependants paying marginal income tax (from a wrapper where investments can grow virtually tax-free) rather than being faced with a flat upfront 40 per cent IHT bill.
After age 75 the lifetime allowance is only relevant for scheme pensions and the annual allowance would not apply to personal, third party and employee contributions.
The new framework will also result in several significant other implications. These are outlined in Box 1.
When might IHT be paid on pensions?
Pensions have always been designed as tax deferred. However, death benefits are now the exception – which does make sense to the extent that death is not tax planning.
Pensions are normally free of IHT, but there are situations where IHT might be due.
For example, contributions could be liable to IHT if the contribution was made within two years of death, and the member was in ill-health when the contribution was made, that is to say, they were unlikely to survive to take pension benefits. It should be noted that, if the contribution was made more than two years before death HMRC will generally assume the member was in good health when the contribution was made, unless there is clear evidence to the contrary.
There are several instances where a pension fund could be liable to IHT. Say, if the member died before 6 April 2011, could have purchased an annuity, moved into drawdown without purchasing an annuity and it could not be shown that in the two years before death the member had no reason to believe they were going to die in those two years.
Finally transfers could be liable to IHT if the transfer took place within two years of death, the member was in ill-health when the transfer took place, the member has made an irrevocable nomination of death benefits in the ceding scheme, and the member does not irrevocably nominate their estate to receive death benefits from the receiving scheme.
Again, if the transfer took place more than two years before death, HMRC will generally assume the member was in good health when the transfer was made, unless there is clear evidence to the contrary, as it does with contributions.
Spouse as primary beneficiary
Pension death benefits are paid as cash and become part of the recipient’s estate. If this value goes unspent, subject to nil-rate bands, it will be subject to IHT at 40 per cent. Nominating the children as beneficiaries or using a spousal bypass trust will solve this problem. But this issue does not go away post-April 2015. The nomination of death benefits becomes even more important.
And finally
It is important that planners continue to put the emphasis on their clients using a pension first and foremost to deliver retirement income and not primarily as a vehicle for passing wealth on to beneficiaries.
Mr Osborne’s changes still lack detail and there are many technicalities which remain outstanding. While it seems as if there is now less reason to delay drawing benefits, it would be prudent to caveat any retirement benefits advice until there is further clarity (although this may not be immediately forthcoming).
Investors generally, where they can, are delaying taking retirement benefits until next year and this would still seem a sensible strategy for the time being. In the mean time, pension funding is becoming increasingly attractive.
Danny Cox is head of financial planning at Hargreaves Lansdown
