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New tax rules on the payment of pension death benefits
Article date: 11/06/2015
Major changes to the tax treatment of pension funds on the death of the pension fund member were introduced by the Taxation of Pensions Act 2014. This may have looked like a minor piece of government legislation that received little press coverage but it will, in fact, have important repercussions for the way people structure and manage their pension pots. With the right legal advice and the implementation of the correct trust structures, the benefits for the next generation could be profound.
The new rules relating to pension funds death benefits take effect for payments made on or after 6 April 2015. This Client Update from Higgs & Sons is designed to explain the new rules for pensions, in particular the position on death and explain the new opportunities available to our clients for their pensions.
In the summer of 2014 the government unveiled its plans to alter the taxation of pensions; rather spectacularly Pensions Minister Steve Webb caught the public's imagination with his quote "if you want to blow your pension on the Lamborghini, that's fine". This was then followed by Chancellor of the Exchequer George Osborne making the following statement in September 2014 "people who worked and saved all of their lives will be able to pass on their hard earned pensions to their families tax free". The new rules that radically reform pensions flexibility and pensions taxation are contained in the Taxation of Pensions Act 2014.
The old position
Prior to the Taxation of Pensions Act 2014 there were a number of possible ways in which pension death benefits could be dealt with. This depended on the member's age at the time of death and what actions they had previously taken in relation to their pension.
If the member died under the age of 75 and before taking their benefits there were two choices either:
1) their nominated beneficiary or dependant could receive the entire pot as a tax-free cash sum; or
2) a dependant could take the pot in the form of a pension and pay tax at their marginal rate.
If the owner died under the age of 75 but after taking the tax free cash, the benefits would be held in income drawdown. Here the choice was between:
1) paying a lump sum to a nominated beneficiary or dependant which would be subject to a 55% tax charge; or
2) the dependant taking the pension pot in the form of a pension and paying tax at their marginal rate.
If the owner died over the age of 75 then two options were available. Either:
1) the payment of a lump sum to one or more of the nominated beneficiaries subject to a tax charge of 55%; or
2) the dependent taking the pot in the form of a pension and paying tax at their marginal rate.
As will be appreciated in certain circumstances the tax charge on the pension pot could be as much as 55%. The alternative was to use the pension pot to buy an annuity or take benefits as income drawdown. In both cases any annuity or drawdown income would be taxable as income on the beneficiary.
The new position
The Taxation of Pensions Act 2014 reduced, in certain circumstances, the effective reduction of the 55% tax charge to zero. In short, in those circumstances, the pension pot can be paid to the next generation free from income tax, capital gains tax and inheritance tax.
The position is particularly advantageous when the pension owner dies before the age of 75. In these circumstances the pension fund can be paid tax free. This can either be in the form of income drawdown payments or a lump sum payment provided the latter is taken within two years of death. This is a considerable improvement on the former position where if a member took tax free cash the pension pot benefits payable on his subsequent death could have been taxed at 55% or if taken as income drawdown, taxed at the beneficiaries marginal income tax rate.
If the pension scheme member dies at age 75 or over, the beneficiaries will only have to pay their marginal income tax rate when they take drawdown income. Alternatively if a lump sum is paid, a 45% charge will be applied for a transitional period in tax year 2015/16 and thereafter benefits may, subject to legislation, be taxed at the beneficiary's rate of tax.
Who can benefit?
On the death of the original member the pension scheme trustees/scheme administrators can exercise their discretion to pay the lump sum to persons who are beneficiaries as defined in the pension scheme rules. If the pension scheme continues in drawdown after the original member's death it is now possible for individuals other than 'dependants' to become entitled to unused drawdown funds.
Any individual can be a beneficiary of such drawdown fund under the new rules. The persons entitled will be either a dependant, a nominee or a successor.
- A dependant remains as defined in the current rules.
- A nominee is someone who is not a dependant but has been nominated by the pension scheme member as a person to benefit from their pension.
- A successor is someone who will become entitled to the pension fund on the death of a dependant, nominee or a previous successor. The successor is someone who can be nominated by either the dependant, the successor of the owner or the scheme administrator.
The new rules create the possibility of pension funds being passed from generation to generation. However this new flexibility can also mean that, without proper planning, the original member of the pension has no control over how the pension will pass after their death.
Owners of large pension pots who have other independent financial means will now be considering whether they should be spending the pensions during their lifetime or whether they should leave them untouched so they can pass on to the next generation free from inheritance tax.
Owners may decide to use other assets that would otherwise form part of their estate in order to support themselves in their retirement. In this way they can leave the pension pot untouched and maximise the inheritance to the next generation. This would have the effect of encouraging people to make additional contributions to the pension funds to enhance their value so that more can be passed on to the next generation in a tax efficient form that other investments cannot.
However, many owners of large pension pots may have concerns about leaving their pensions untouched and passing on such large sums to their successors if they do not have the control over who the ultimate beneficiaries will be. Owners may have concerns that where their beneficiaries are on second or subsequent marriages and they die that the surviving spouse as dependant may remarry and name the new spouse as a successor to the pension. This is where prudent planning and the use of trust structures to receive the pension funds give greater control and security to the owner. Lifetime trust structures will also help to further avoid tax charges on the removal of cash from pension fund if the surviving spouse dies having attained the age of 75 years.
It should be remembered that the current Lifetime Allowances on pension savings (currently £1.25 million) still applies. However, the good news is that an inherited pension pot will not form part of the beneficiaries' lifetime allowance on pension funds.
Undoubtedly many pension owners will cash in some of their entire pension under the new rules in order to pay for luxury holidays, home improvements or even perhaps buy a brand-new Lamborghini. The government suggests that this is unlikely to happen because people will feel that they can leave more money to their families in a tax efficient way so that they are less likely to spend their pension pot.
Higgs & Sons recommend that working with professional advisors such as accountants and financial advisors that clients undertake a review of their pension and also their wealth planning structures in light of the new changes. Many clients will welcome the ability to pass on pensions from generation to generation but the lack of control on who the pension fund can eventually pass to will cause some concern to pension owners. This is of particular concern where the surviving spouse may remarry which could mean that the entire pension pot may pass to the new spouse thus disinheriting the children from the first marriage. As always, appropriate legal structures and the use of trusts may be appropriate for pension pots in order to provide protection for the wealth of the family passing from generation to generation.
For more information about the Taxation of Pensions Act 2014 and how the changes impact on your pension please contact Ian Bond; his team of experts can guide you through the legislative changes and opportunities available to you. If you would like more information or to discuss your pension death benefit planning please contact us on 0845 111 5050.