Benefits buried within new death tax legislation

Previously, the compelling answer was to leave it in a trust in many circumstances, but with the new legislation, it is definitely something that needs more consideration.

Trusts have always been a common option for receipt of death benefits within a pension scheme, particularly where benefits were uncrystallised. In such circumstances benefits were usually paid to the trust free from inheritance tax (IHT), which would be the same as if it had been paid directly to a beneficiary. Although a payment directly to a beneficiary would become part of their estate, so subject to IHT on their death. This would not be the case if funds were paid into a trust, as the trust could distribute funds to a wide variety of beneficiaries.

Trusts were less popular when the benefits had been crystallised because of the 55 per cent tax charge on crystallised lump-sum death benefits. In these circumstances it was often more tax efficient, where possible, to leave income to a dependent within the pension scheme. The income was, however, likely to be restricted and taxed at the recipient’s marginal rate. On the beneficiary’s death any residual fund would then be paid out as a lump sum less the 55 per cent tax charge.

Trusts are subject to periodic charges every 10 years or on distribution of assets, but this was generally significantly less than any IHT that would be payable otherwise.

The new legislation introduces two major changes in the treatment of pension death benefits: the first is the removal of the 55 per cent tax charge on lump sums paid from crystallised funds; the second is the ability to name any beneficiary to receive income from the fund, rather than it being limited to a dependent of the original member.

The removal of the requirement for income only to be paid to a dependent opens up a greater number of options for nominations. In addition, on second death there is no requirement for the residual fund to be paid out. The capital can remain within the pension scheme and be passed onto a new beneficiary of the person receiving the income at that time of death.

This move means that money can pass down or across generations without being subject to IHT charges and, in cases where the death of the person receiving the income is before age 75, it isn’t subject to income tax or any pensions death tax upon distribution to the deceased’s survivors. It is still possible for the beneficiary to take the option of a lump sum, again tax-free if pre-age 75, or for a bypass trust to be nominated to receive the subsequent death benefit.

If a person rather than a trust takes the fund as a lump sum, there may be no tax on the original distribution to that person but there will be tax charges on any income and gains arising on these funds once in the hands of the beneficiary. This would not be the case should the funds be left within the scheme to invest.

It is clear that reviewing the nominations are essential now with these changes already in force. Advisers need to discuss with clients and their families the best option to achieve their wishes after they die. The choice of nomination not only affects how the money is paid and taxed at the point of death but how the investments will be taxed on an ongoing basis.

Claire Trott is head of technical support at Talbot and Muir

KEY POINTS

Death pre-75

Payable to any beneficiary

• Lump sum paid free of tax; or

• Beneficiary’s flexi-access drawdown – growth tax-free under usual pension rules. Income paid free of income tax.

If benefits are uncrystallised they will be tested against the lifetime allowance on death.

Death post-75

Payable to any beneficiary

• Lump sum subject to 45 per cent flat-rate tax (due to change to marginal rate from tax year 2016-17); or

• Beneficiary’s flexi-access drawdown – growth tax-free under usual pension rules. Income paid subject to income tax at beneficiary’s marginal rate.

Government’s view

In his speech at the Conservative Party Conference in September 2014, chancellor George Osborne spoke about pension freedoms, adding:

“But I want to go further. There are still rules that say you can’t pass on to the next generation any of your pension pot when you die, without paying a punitive 55 per cent of it in tax.

“I could choose to cut this tax rate. Instead, I choose to abolish it altogether. People who have worked and saved all their lives will be able to pass on their hard-earned pensions to their families tax free.

“The children and grandchildren and others who benefit will get the same tax treatment on this income as on any other, but only when they choose to draw it down.

“Freedom for people’s pensions. A pension tax abolished. Passing on your pension tax free.”