Passing on a pension fund is nothing new of course. However, before the recent changes the obligation has always been that pension death benefits need to be distributed to a ‘financial dependent’ first and foremost (a financial dependent typically being a spouse/civil partner or a child under the age of 23). From 6 April this changes and anyone can be nominated to receive a pension death benefit.
| Age | Uncrystallised | Crystallised |
| <75 | Lump sum or income on death can be passed on tax-free to any beneficiary (up to the deceased’s lifetime allowance) | Lump sum or income pension can be passed on tax-free to any beneficiary |
| 75+ | Any beneficiary can draw down on the fund at his marginal rate of tax or 45% charge if paid as a lump sum (changing to marginal rate from 2016/17) | Any beneficiary can draw down on fund at his marginal rate of tax or 45% charge if paid as a lump sum (changing to marginal rate from 2016/17) |
While no-one can predict his demise, these welcome changes now offer greater potential to pass on a pension fund with smaller tax deductions. It is now possible for someone’s pension to become a lasting family legacy as a result of it passing to a nominee, who in turn can appoint successors to inherit thereafter.
For estate planning purposes, there should be no inheritance tax payable by the person inheriting the pension pot. Similarly, there should no lifetime allowance to worry about either. That said, this needs to be caveated and it is worth revisiting the current rules and putting these in perspective with the changes due to take effect in April this year.
The existing rule that distribution of death benefits must be paid within two years still applies, but for those who have died in recent months it is perfectly legal to delay the distribution of death benefits until 6 April 2015 to take advantage of the forthcoming changes. For many estates, two years is considered ample time. However, if there are family disputes or it is unclear who the beneficiaries are, then two years is not long at all. If distribution of death benefits occurs after two years, then the flat rate of 45 per cent tax or the recipient’s marginal rate of tax applies (where previously this would have suffered an unauthorised payment charge of 70 per cent).
Spousal bypass trusts
Another potential issue is the use of a pension trust as a vehicle for parking death benefits. For many, spousal bypass trusts have helped avoid or mitigate a surviving spouse’s inheritance tax position. Now, their use is being called into question given the 45 per cent tax charge that will apply to death benefits paid into trust after age 75, which is when the individual is more likely to die.
First, it should be remembered that spousal bypass trusts come in two main varieties: a pilot trust and an integrated trust. Death before age 75 is not an issue, however, for those who may wish to circumvent the 45 per cent tax due on death benefits paid into a trust after age 75, the ability to revoke the trust will be important. For spousal bypass trusts, the key difference is that pilot trusts are revocable whereas integrated trusts are not. For those concerned about existing integrated trusts then a transfer of the pension scheme (internally or externally) can break the trust if this is considered necessary. Moving forward, a pilot trust could be the preferable option, as this can be revoked at age 75 in favour of a beneficiary whose marginal rate of tax is less than the 45 per cent that would otherwise apply. Perhaps the natural question to ask is whether an individual is prepared to pay 45 per cent tax in order to retain protection and control over his estate.
As iniquitous as this tax charge may appear, there are circumstances where it can still offer value from a cost-benefit analysis. Particular examples include divorce, bankruptcy and long-term care. For long-term care planning, pension death benefits held in a spousal bypass trust are not taken into account as they are not means tested because it is a discretionary trust. Similarly, for divorce cases, these trust assets are ring-fenced against the matrimonial estate. Being discretionary, the spousal bypass trust itself will be subject to the usual inheritance tax treatment of a 10-yearly periodic charge (up to 6 per cent of the value of the trust) as well as a maximum exit charge of 6 per cent, but this tax should appear negligible against the backdrop of the wider motive for using the trust.
Annuities
One consequence of the Budget sees the removal of the 10-year guaranteed period for annuities. While annuities seem to be declining in popularity, when it comes to estate planning, it is important to remember that the way in which benefits are paid during the guarantee period needs to have an element of discretion in order to be immune from inheritance tax. If there is an explicit intention to distribute death benefits to the annuitant’s estate, the benefit will be subject to inheritance tax. This is nothing new, but is a useful pointer for those unsuspecting annuitants who may not be aware of this.
Potential pitfalls are with section 32 and section 226 pension arrangements whereby the default pension arrangement is not likely to be in trust. The reality is that these types of pension arrangements are becoming rarer. However, any current section 226 policy is likely to have substantial value given that they have been around for many years. Unless a trust has been added after inception, the death benefits paid from a section 32 or 226 policy will be subject to inheritance tax.
Benefits
In terms of funding a pension, one also needs to be careful when making ‘death-bed’ pension contributions as these will also be caught by inheritance tax. If someone in poor health is considering maximising contributions through carry forward, for example, and he dies within two years, then all this contribution may be assessed as part of his overall estate for inheritance tax. To circumvent this issue, it is perfectly acceptable for someone in ill health to assign the death benefits of his pension into trust. In doing so, the death benefit is paid to the trustees rather than the member’s estate, and being a discretionary trust there is subsequently no inheritance tax. Regardless of health, any pension contribution made after age 75 will not receive tax relief, although it will likely be outside an individual’s estate for inheritance tax purposes.
For many, this feature will not be an issue, but given we are constantly being reminded about how much longer we are living and as a result how much longer we appear to be working, more individuals will likely encounter this issue. Before the Budget last year, there was hope George Osborne would revisit this feature. However, the most recent autumn statement clarified that this remains unchanged.
Crystallisation event
Finally, one post-budget change that seems to have gone unnoticed is the introduction of a new benefit crystallisation event. Under the current regime, those dependents who receive an income from an uncrystallised pension on death before age 75 are exempt from a lifetime allowance test on the basis that their dependent’s income is taxable. From April 2015, a new benefit crystallisation event ‘5C’will see a 25 per cent tax charge on any excess above the lifetime allowance on a dependent’s income. This will therefore close the potential loophole of a dependent being able to receive tax-free income for uncrystallised funds in excess of the lifetime allowance.
Regardless of whether the pot is crystallised or uncrystallised, pensions now provide fantastic flexibility to pass on the money tax-free. With prudent planning and a suitable trust established, death after age 75 can be equally compelling. For younger generations struggling to get on the housing ladder or those wishing to fund private education, these are welcome changes.
Historically, pensions have never tended to feature low on the radar when discussing inheritance tax, but it is clear that using a pension should now feature on the agenda for those keen on adopting a holistic approach towards estate planning.
Craig Harrison is head of Creative Wealth Management
Key Points
* From 6 April anyone can be nominated to receive a pension death benefit
* There should be no inheritance tax payable by the person inheriting the pension pot
* In terms of funding a pension, one also needs to be careful when making ‘death bed’ pension contributions as these will also be caught by inheritance tax