InvestmentsMay 9 2016

Common pitfalls in planning inheritance

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Common pitfalls in planning inheritance

Transferring wealth through the family, for most, is an important part of their inheritance-planning process.

But until recently, it had been problematic to include pension funds in this process. Under the newly formed pension freedoms legislation, which began on April 6 2015, pensions can now easily be included.

There may be pitfalls along the way, with many outdated pension contracts not allowing this full flexibility.

First, it is important to understand that there is a difference regarding the tax treatment of how pension funds may be withdrawn, subject to the age of the member on death.

The death of the pension fund member before age 75 allows for the inheriting individual to receive the fund as a pension in their own name, free of tax. They may also withdraw the entirety of this inherited fund in their own name without being liable to income, inheritance or capital gains taxes.

On death after age 75, the pension fund is passed to the receiving individual, again tax-free. But if they wish to withdraw it as an income or a lump sum, they must pay income tax at their marginal rate.

In both scenarios, the pension fund can be inherited as a pension and no tax is incurred. Taxes may only be liable where a member died after age 75 and the capital of the pension fund is being withdrawn.

Naturally, under pension freedoms, an individual may choose when to draw pension income and when not to, though this is slightly different between defined benefit and defined contribution schemes.

PENSION INHERITANCE - Paying tax

There are other circumstances in which an individual inheriting a pension fund may have to pay tax, according to HM Revenue & Customs (HMRC).

Taxes may be due if the pension pot’s owner was under 75 when they died and any of the following apply:

■ If the inheritor is paid more than two years after the pension provider is told of the death;

■ If the pension savings were worth more than £1m;

■ If they died before December 3 2014 and the inheritor buys an annuity from the pot.

Paying tax if the inheritor is paid more than two years after the provider is told of the death.

In this instance, HMRC notes the inheritor will pay tax if the pot’s owner was under 75, and if the inheritor receives either:

■ An annuity or drawdown fund from an ‘untouched’ pot – the person who died didn’t take any money from it;

■ Most types of lump sum from defined contribution or defined benefit pots.

In both cases, the provider will deduct income tax before the inheritor is paid.

Paying tax if the person who died had pension savings worth more than £1m.

HMRC notes the inheritor will only pay tax on payments in this scenario if all of the following apply:

■ The savings are from an untouched pot (the person who died didn’t take any money from it);

■ The inheritor received the pot within two years of the provider being told about the death;

■ When the pot is added to the person’s other untouched pension savings, the total is more than what’s left of the person’s lifetime allowance.

Source: HM Revenue & Customs

Under a defined benefit scheme there will be a standard retirement age, whereby benefits come into payment at that point – although an individual may retire sooner or later – and there is no capital sum as such to be inherited.

In these scenarios it is impossible to inherit a pension fund, although there may be provision for a pension income to any spouse/partner/dependant.

Prior to drawing the income, a transfer of benefits to a defined contribution arrangement may be elected, to allow capital to be inherited on death. This would involve the surrender of the final salary pension, so careful consideration is needed.

For a money purchase pension scheme there is always a capital lump sum – if it has not been previously converted into an annuity – which is now voluntary.

There are a wide number of personal pension contracts and retirement annuity contracts that have automatic annuity purchase built into them at the selected retirement age of the individual.

Under these contracts, holding them until the retirement date will see the ability to transfer lost and an annuity automatically acquired.

Prior to drawing the income, a transfer of benefits to a defined contribution arrangement may be elected, to allow capital to be inherited on death

Hence any individual wishing to delay the withdrawal of income from their pension fund beyond the standard retirement age of their current pension contracts should investigate if they are able to defer retirement, or indeed transfer the pension fund to an alternative arrangement that is able to help them reach their own personal objectives.

Annuity purchase may be available at a preferential rate, which is established at the start of the arrangement. A quandary then presents itself between drawing this rate – with little capital inheritance – or forgoing a potentially attractive annuity rate to allow for inheritance of capital.

Under certain pension contracts, retirement cannot be delayed past age 75. There are self-administered pensions known as small self administered schemes (Ssas) and self-invested personal pensions (Sipps), which provide the individual with the ability to defer income withdrawal beyond age 75, and thus increase the ability of the pension fund to be inherited.

Legislation permits for one individual to pass their pension fund to another, and for the recipient to do so also.

Therefore pension capital – if it is not withdrawn from the pension wrapper – can cascade through a family tax-free on death ad infinitum.

Naturally, careful consideration should be given to the type of pension scheme used, with self-administered pensions potentially offering flexibility in adding and removing members through the generations to achieve this objective.

Adrian Mee is a consultant at Mattioli Woods