RegulationMay 31 2013

Tax treatment of pension funds after vesting

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Both pre- and post-A-day on 6 April 2006, one of the key drivers behind an investor’s selection of income drawdown was the attraction of the death benefits compared to annuitisation. Today, the deciding factor is more likely to be to avoid locking into depressed annuity rates. However, the death benefit position remains a central planning issue.

Death benefit payments

On the death of a member of a registered pension scheme, their dependants may receive an increase in pension rights via the scheme pension, annuity, drawdown or the lump-sum death benefit.

For this purpose a dependant is defined as being the spouse or civil partner of the member at date of the member’s death; a child of the member under 23; or a child of the member over 23, but dependent on the member due to physical or mental impairment.

A person who was not married to/a civil partner of the member at date of the member’s death and is not a child of the member is also considered a dependant if the person was financially dependent on the member; the person’s relationship with the member was one of mutual dependence; or the person was dependent on the member due to physical or mental impairment.

Where there are no dependants, there is the option to pay a tax-free lump sum to a charity. The charity must have been nominated by the member. A tax-free charitable lump sum can also be paid alongside a taxable lump sum, for example, part can be paid to charity and part as a taxable lump sum to non-dependant relatives.

The tax position of death benefit payment options is outlined in Table 1, along with the impact of crystallisation and details of how tax treatment varies pre- and post-age 75.

Planning considerations

Clearly the option of tax-free death benefits is preferable to a taxable income or taxed lump sum. Leaving a money purchase fund unvested provides the potential for a tax-free dependant’s inheritance up to age 75. This is also likely to be a better option for those in ill-health than an impaired life annuity unless income is a necessity. Of course vesting can be phased to leave some tax-free uncrystallised segments.

However, this strategy should be offset against the probability of survival to age 75, which is currently somewhere above 80 per cent.

Planners should consider the relative attraction of the immediacy of lump-sum death benefits taxed at either zero (unvested, pre-age 75 and lower than LTA) or 55 per cent (vested, post-age 75) compared to income, secured or otherwise, taxed at potentially significantly lower rates, even tax-free within the rising personal allowance. Additional income might also be gifted tax-free under the normal expenditure exemption.

Death benefits and the lifetime allowance

A dependant’s pension, charitable tax-free lump sum and taxed lump-sum benefit do not trigger a benefit crystallisation event (BCE) and so will not be tested against the lifetime allowance (LTA) of either the deceased member or the recipient. A tax-free lump sum does trigger a BCE and is tested against the deceased member’s LTA before payment. Therefore, a tax-free lump sum payment could be liable to an LTA charge. An example of this is shown in Box 1.

Spousal Bypass Trusts

Where a pension scheme offers lump-sum death benefits, if these benefits are ‘normally’ free of inheritance tax (IHT) then they will generally also be free of IHT when paid to a trust. A ‘spousal bypass’ trust may be used to minimise IHT on second death by keeping any death benefits outside of the surviving spouse’s estate while still allowing them potential access to the funds.

To do this, the member sets up a pilot trust with a nominal sum and makes a nomination for death benefits to be paid into this trust. There is no obligation for the pilot trust to be used as a spousal bypass trust.

Under a spousal bypass trust, the pension scheme lump-sum death benefits (less any applicable tax) are paid straight to the trust as cash. Under the terms of the trust, the trustees have the ability to distribute monies at their discretion. The surviving spouse can be named as a beneficiary, therefore monies can be released to them in their lifetime if required. The surviving spouse is usually one of the trustees so has some control over this process.

Funds held in a spousal bypass trust are not deemed to be in any of the beneficiaries’ estates. The advantage behind this arrangement is that the value of the death benefits are held in the trust, free from IHT on the surviving spouse’s death, to be released to the beneficiaries (usually children or grandchildren) when appropriate.

Funds that are paid from the trust to the spouse come into the spouse’s estate and on death are subject to IHT. It is possible to make loans from the trust rather than direct payments of trust assets. This creates a debt against the spouse’s estate which can reduce IHT liability on their death.

Lump-sum death benefits for uncrystallised funds are generally paid tax-free before age 75 and therefore a spousal bypass trust may effectively remove a substantial amount of capital from the surviving spouse’s estate. Lump-sum death benefits for crystallised funds and for all funds after age 75 are taxed at 55 per cent, therefore a dependant’s pension income would typically be the more attractive option in these circumstances.

Spousal bypass trusts may also be useful where the spouse is unlikely to need access to any of the lump-sum death benefits, regardless of a 55 per cent tax charge.

Danny Cox is head of financial planning at Hargreaves Lansdown