Using pensions for intergenerational IHT planning

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.

These three aspects combine together resulting in IHT benefits that are hard to match: pension contributions should have no IHT consequences; the funds held within beneficiary drawdown are outside of the IHT estate; there is no tax to pay on drawdown death benefits paid following death before age 75 and just marginal rate tax for later deaths. 

Couple this with the ability to use beneficiary drawdown to pass wealth down through the generations by nominating any beneficiary and successor beneficiaries to receive drawdown after the member or previous beneficiary’s death, and you’re left with a straightforward, tax-efficient solution to avoiding IHT on substantial amounts of capital for an indefinite period of time.

There’s rarely a free lunch, so there are some drawbacks to point out. Firstly, the amount that can be contributed to a pension each year is limited by the annual allowance – as low as £10,000 or £4,000 for those who’ve started taking flexible income – preventing large sums being accumulated at once. Second, IHT planning is a secondary benefit of pensions behind retirement planning for those who can afford to use their pensions more flexibly. And finally, the non-binding nomination approach which leaves the final decision over the recipient of death benefits to the scheme trustees may not sit well with everyone.

Those that are comfortable with the trustees’ discretion over death benefits and have some scope to use a pension for IHT planning, however, will appreciate its simplicity and flexibility. All that is required is to set up a personal pension and keep the nomination of beneficiary up to date. For those with little or no need for their pension income, this may be an appealing approach when compared to the complexity of setting up a trust, completing deeds to amend and appoint trustees, the complex taxation position of many trusts and the often high legal fees.

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This is a Scottish Widows Paid Post. The news and editorial staff of the Financial Times had no role in its preparation