Estate planning – One size fits all

Previously, the tax position of the death benefits of personal pensions (including stakeholders and Sipps) was dependent on whether benefits were in payment and the age at death, with a top rate of tax at 55 per cent for those in drawdown who died aged 75 or older.

Under the new rules, age 75 remains a key measurement point in terms of the taxation of death benefits.

Occupational schemes

Death in service lump sums remain tax-free. Occupational scheme widows’ and dependants’ pensions continue to pay income which is taxed at the marginal rate of the beneficiary.

Defined contribution money purchase occupational company schemes almost always follow the same rules as personal pensions, but there are exceptions: for example if scheme pensions are purchased by the trustees the income is taxable.

IHT treatment of pensions

Pensions are typically held in trust outside an estate, beneficial payments are “discretionary” and remain free of inheritance tax (IHT) in most cases. However contributions made while in ill health or within two years of death may still be liable to IHT.

Estate planning with personal pensions

As shown in the Table, the type and amount of tax paid upon exit from a financial product is a key part of its value assessment.

With the prospect of zero tax on death before age 75, a pension pot becomes a tax-free inheritable pot to preserve if surplus to requirements – essentially a hedge against early death, with income tax relief up to 45 per cent upon entry and potentially no tax on the way out (subject to Lifetime Allowance assessments).

However given that statistically four fifths of those who reach age 65 will survive past age 75, this planning will not work more often than not. That doesn’t necessarily mean this strategy is not viable: the beneficiaries’ marginal tax rate (particularly through a drawdown arrangement where income is taken over a number of years) could result in much lower tax rates, and zero if within the personal allowance (£10,600 in 2015/16).

Where the client’s estate exceeds the nil-rate band (NRB), from an IHT perspective, it is more tax-efficient to run down the taxable estate in preference to pension. This includes using Isas to supplement income or capital needs.

If Isas are being used to top up the client’s income (for example where the client is a higher-rate taxpayer due to secure pension income or other taxable sources) the Isa wrapper can now effectively pass onto the spouse to continue to benefit from the tax-free income.

The inherited pension may be the first point at which a beneficiary has held a significant amount of capital

Planning for the beneficiary

The inherited pension may be the first point at which the beneficiary has owned a significant amount of capital. Advice can make a huge difference to them in the long-term.

There is no age restriction on accessing beneficiary’s drawdown and so it could be a useful resource in times of low income (e.g. university, maternity breaks and sabbaticals).

A beneficiary should only take income from the pension wrapper as and when required to preserve the tax wrapper as far as possible.

Death benefit nominations

The tax value of the pension diminishes the moment it moves out of its wrapper. Pay the death benefits to the wrong person and the cash now in an estate is fully subject to IHT.

Therefore clients must make their beneficiary nomination to the right people. Clients must also understand that a death benefit nomination form is not binding. The pension trustees are obliged to consider the needs of any financial dependants in the first instance.

The client has no control over timing/amounts of distributions to beneficiaries after their death. For example, the first beneficiary could exhaust the fund and leave nothing for future generations.

This may be a particular concern where the client wants to provide for a surviving spouse but has children from a previous relationship.

Overfunding pensions now IHT efficient

Should advisers recommend clients overfund their pensions? While these contributions would not benefit from tax relief they would be subject to the favourable death benefit tax treatment.

For me it would take a rare set of circumstances for this to be viable, given that ultimately pension benefits will be subject to income tax on death post age 75. Using this money to make direct gifts to a beneficiary’s pension or Isa is more preferable in my view.

What about spousal bypass trusts?

Spousal by-pass (or pilot) trusts are largely redundant now because they would take the death benefits out of the tax shelter and into discretionary trust tax regime. They are only really suitable if the desire to take control for the timing and amounts of distributions from the death benefits will justify the increased taxation.

However, it may occasionally still be appropriate to use spousal bypass trusts to receive death benefits, where the client wants to retain more control over who receives the benefits and when.

Once benefits are passed into a beneficiary’s drawdown the future use and distribution of those benefits is effectively in the hands of the beneficiary.

The beneficiary can choose to spend all the money, so that it is lost to future generations. They can also effectively decide who receives the benefits on their death, by nominating their beneficiaries.

Action point

Clients who have previously nominated a spousal bypass trust to receive their pension benefits on death should review whether this still meets their needs.

They also need to check their nomination of beneficiaries is up to date and that their strategy on gifting is still relevant.

Clients should also review their will to take account of the changes to the taxation of pension death benefits.

Danny Cox is chartered financial planner and head of financial planning at Hargreaves Lansdown