Since the government announcement on pension legislation changes in the March Budget, a commitment to reduce the taxation of death benefits from pension funds has been expected. However, the timing and the extent of these proposed changes confirmed by George Osborne on Monday at the Conservative Party Conference has taken everybody by surprise.
What is the situation currently?
For the majority of Defined Contribution (also known as money purchase) pension schemes, any lump sum benefit payable on death from a pension where benefits have not been taken, is payable as full return of fund which is tax free. As pensions are set up under a trust, this payment does not require probate, and is not part of the deceased’s estate for the purposes of any calculation of Inheritance Tax.
For pension funds that have been used to provide benefits via income drawdown (or where death occurs after 75 years of age) the fund is subject to a 55% tax charge if paid as a lump sum. This penal level of tax can be avoided if the fund is used to provide an income, but the income can only be paid to a dependant as defined by pension legislation, and this income is taxable at the marginal rate of the recipient.
HMRC have long been opposed to the concept of passing pension benefits to future generations, and the argument in favour of the 55% tax charge is that it allows a pension in payment to provide a lump sum payable to anybody which is not the case with other retirement options such as an annuity (typically only allows the continuation of income to a spouse).
What is changing?
From April 2015, any pension benefits payable on death before 75 will be tax free if taken as a lump sum, or if taken as income via the new flexible drawdown arrangements. On death after 75, any lump sum is taxable at a rate of 45%, but income can be paid to any beneficiary and taxed at the marginal rate of the recipient.
It should be noted that, regardless of when the policyholder dies, if the fund is used to provide an annuity, the recipient will pay tax on this income in all cases.
What does this mean if death occurs prior to April 2015?
If benefits have not been taken and death occurs prior to age 75, there is no difference as to how death benefits are taxed. However if benefits are in drawdown, a lump sum paid before April 2015 would be taxed at 55%, but any lump sum payable after April 2015 would be tax free (if the policyholder was under 75 at time of death).
The option on taking the lump sum from a drawdown policy can be deferred for up to two years, and so if payment of death benefits is delayed until after April 2015, the lump sum tax charge can be avoided.
What planning opportunities do these changes represent?
The proposals to allow people full access to their pension funds from age 55 will make investing in pensions much more attractive to many people, and the opportunity to pass this benefit onto family members’ tax free on death will only increase their appeal.
The fact that the lump sum or income can be passed on tax free to any beneficiary means that pension funds can become genuine family savings plans that will allow assets to be passed down the generations.
Even in cases where death occurs after 75, the fact that income can be paid to any beneficiary, and is taxable on the recipient, makes the use of a pension to fund education costs for grandchildren very attractive.
Every UK resident (including newborn children) has a personal allowance – this is the level of income below which no income tax is payable, and for the 2015/16 tax year is expected to be £10,500. This means that a pension fund where the policyholder was over 75 on death, can be used to pay up to £10,500 every tax year to multiple beneficiaries (including children); if the recipient has no other income, this payment will be tax free. With a bit of planning, a pension fund could be used to fund school and university fees for grandchildren with no tax payable at all.
What needs to be done now?
The proposed changes make it even more important that pension administrators are aware of the wishes of the policyholder for the payment of benefits on death. You should check with your pension provider to ensure that a nomination of beneficiary form has been completed, and that it is up to date – the nomination can be changed at any time, and multiple beneficiaries can be named.
In the absence of a completed form, the provider will have to make a decision as to whom benefits should be paid to which will delay payment, and could see payment paid to the wrong persons.
While pension benefits are not liable to Inheritance Tax, any lump sum paid is part of the recipient’s estate, and may be liable to Inheritance Tax on their death (which could be up to 40% of the inherited amount).
The impact on Inheritance Tax can be avoided by ensuring that any benefits on death are payable to a trust instead of a named individual – this ensures that benefits remain outside of Inheritance Tax considerations for multiple generations. For many middle aged individuals, their pension fund could be the second biggest asset they own after their home, and if their assets are above the current Nil Rate Band of £325,000, then a Death Benefit Trust should be seriously considered.
What is next?
As always with these announcements, the devil is in the detail (we’ve already seen the announcement in March of free face to face advice for all retirees being subsequently diluted to guidance) and the full picture will only become clearer in the Autumn Statement on 3rd December 2014.
The fact that income from an annuity on death will continue to be taxed means that the popularity of annuities will wane. However, the Autumn Statement is likely to see changes in annuities such as proposals to vary income, and receipt of lump sum benefits on death so there may yet be a place for them in the new regime.
The pension landscape will be unrecognisable in six month’s time to that which was in place at the beginning of the year, and we would strongly encourage all investors to seek advice and ensure that they use the new opportunities to the maximum.
