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Using pensions for intergenerational IHT planning

Whether by design or by accident, pension drawdown has become one of the simplest and most effective inheritance tax (IHT) planning vehicles around.

Think of IHT planning and your mind will immediately be drawn to trust deeds, witness signatures, complex tax rules and eccentricities like the stapling of a £20 note to a declaration of trust. Traditional trust planning along these lines still has its place and will be the appropriate route for many individuals, particularly with large estates. However, a new avenue to IHT planning has opened following changes in April 2015 to money purchase pension death benefits.

The funds held within a pension have long been exempt from IHT barring a handful of exceptions mostly when the scheme member is aware of serious ill health. These aside, contributions to schemes and transfers between schemes can proceed without IHT consequence. This has been – but for some minor tinkering along the way – the status quo for many years. 

That covers the position during the scheme member’s lifetime. However, what is more important for IHT purposes is the position after their death. Until April 2015 the range of individuals that certain death benefits could be paid to was quite narrow. Lump sum death benefits have always been available to any beneficiary, but this doesn’t always help from an IHT perspective as the lump sum payment takes the funds away from the tax-efficient pension wrapper and into someone’s estate. Paying death benefits into a drawdown arrangement, where they remain within the IHT-efficient pension environment, can be preferable.

However, until April 2015 drawdown for death benefits could only be established for dependants. This generally meant only a spouse, minor child or some other ‘financial dependant’ could receive drawdown and so there wasn’t much scope for drawdown to continue for a long period of time: at some point the funds would have been paid out in the form of a lump sum as there were no dependants remaining.

This was changed when the pension freedoms were introduced in April 2015 allowing drawdown holding death benefits to be set up for anyone who was either dependant or was nominated a beneficiary. So ‘beneficiary drawdown’, as it’s referred to, can be established for dependants and non-dependants. A further change was the new concept of a ‘successor’, who could be nominated by the current beneficiary to receive drawdown after their death. This succession of death benefits can carry on indefinitely or until the funds are exhausted, with the undrawn capital always remaining within the IHT-efficient pension wrapper.

The income tax treatment of beneficiaries was also improved from April 2015. If the scheme member dies before reaching age 75, the beneficiary pays no income tax (apart from a potential lifetime allowance charge) on death benefits from a money purchase scheme. A successor is treated the same but it is determined by the age the previous beneficiary died. And if death is on or after age 75, the beneficiary pays marginal rate tax on death benefits.