Death and taxes

But prompt action may be needed to ensure their wishes can be met before it is too late. Many pensions have been around for years – designed with a very different retirement journey in mind – and may not offer the new options.

The consequences of dying while stuck in a pension scheme which does not offer the new freedoms, or with an outdated death benefit nomination, may be impossible to correct after death. Therefore, it may be necessary to consider transferring existing pensions to more modern ones which are fully flexible.

There were two significant changes to DC pension death benefit rules from 6 April. These will trigger the need for a rethink around how pension wealth is passed on:

• Who can benefit: The new rules no longer restrict a continuing pension income to a dependent. Pension savings can now be passed to any nominated individual to draw an income from, while remaining in a tax-privileged pension wrapper through inherited drawdown.

• The tax they pay: Age at death now determines the tax treatment of pension death benefits. There is no longer any taxation distinction between benefits provided from crystallised and uncrystallised funds (ignoring LTA issues).

• Pre-75, any pension death benefits can be paid tax-free. This includes both income payments through inherited drawdown and as a lump sum.

• Post-75, the beneficiary pays income tax on the money he draws, whether this is taken all in one go, or as a series of income payments.

• For individuals, the same tax treatment applies to both income and lump sums provided on death (for 2015/16 only lump sums will be taxed at 45 per cent).

• Payments to a trust after 75 will always be taxed at 45 per cent.

So what will this mean for advice?

So much has changed that it will require a reassessment of what pension savers would like to happen to their fund.

For the first time pension wealth may be passed to adult children within the pension wrapper rather than as a lump sum. And there is no requirement for them to wait until they reach age 55 to access it.

The tax benefits of this option are threefold:

1. The fund remains invested in a tax-free environment, with income and gains free from income tax and CGT.

2. The pension fund also remains outside the beneficiary’s estate for IHT and does not count towards his own pension lifetime allowance. The fund can continue to remain in the pension wrapper even after the beneficiary’s death as they too can nominate a successor.

3. The tax on income withdrawals is determined by the deceased’s age on death.

A popular way of passing on pension wealth tax efficiently has been the use of a bypass trust. The pension death benefit lump sum is paid to a discretionary trust from which family members can benefit.

The ability to keep the funds outside the spouse’s or any other beneficiary’s estate can now be mirrored through the new inherited drawdown. If this was the primary purpose of setting up the bypass trust, it will be necessary to review whether it is still appropriate going forward. Where death is after age 75, the amount going into the bypass trust will suffer a 45 per cent tax charge.

Capital distributions from the bypass trust are not taxable in the beneficiary’s hands – although there may be an IHT exit charge to pay when capital leaves this trust. Trust IHT charges can be complicated, especially where they involve pension death benefits, and the trustees may require the help of a tax specialist.

Laws and tax rules may change in the future – the information here is based on our understanding at May 2015. Your client’s personal circumstances also have an impact on tax treatment.

Dave Downie is technical manager at Standard Life