The government’s big budget shake up of pensions has potentially created an entire new level of freedom and income flexibility in retirement. It also presents a whole new perspective for inheriting pensions and inheritance tax planning for retirees with larger pension pots.
It is highly likely that the removal of compulsory annuity purchase will lead to a greater number of retirees choosing a drawdown style pension that allows them to take an income directly from their fund. With these changes more pension wealth than ever will be potentially passed down to loved ones on death and its vital to plan for this in advance and reduce any tax.
How these death benefits may be taxed will hinge on the governments review of the current regime. Any “uncrystallised” fund where the benefits have not been taken can pass to the estate of the deceased without a tax charge. Where a tax free lump sum has been paid then this “crystallised” fund is subject to a 55% tax charge if the remaining money is paid out as a lump sum on death.
If death occurs after age 75 and the surviving spouse wanted to take the uncrystallised fund as a lump sum (including any of the unused tax free cash allowance) it would all be subject to the 55% recovery charge that applies to crystallised funds at any time after age 55.
For many spouses this charge already acts as a deterrent from taking the lumps sum option, opting to continue to receive an income from the fund with it taxed against their own personal allowance. But what about those who already have a sustainable income or wish to pass the money onto their children?
The government has stressed their belief that pension savers should not be penalised for using their funds sensibly, so is this review likely to result in a reduction of this tax? Well there are a few possibilities on the table.
Some have speculated that the charge could be based on income tax rather than a flat 55%. On first sight this seems a fair idea, especially to basic rate tax payers, however your fund doesn’t have to be that large before you suffer a 40% charge and if your fund goes into six figures then this could be up to 45%.
One alternative could be to include the lump sum from drawdown in the deceased’s estate when calculating inheritance tax (IHT). This would seem a lot fairer and would mean that a spouse or civil partner would be exempt from tax under the normal IHT exemptions. Any other recipient would have 40% IHT deducted if the overall value of the deceased’s estate exceeded their nil rate band (currently £325,000), with smaller estates much less likely to suffer a tax charge in this way.
With this shift away from annuities controlling the eventual destination over who eventually benefits could be just as important a factor and any surviving spouse who inherits a pension fund also needs to think about the eventual impact on their own estate.
Using a bypass trust may be one way of doing this. It provides an element of control beyond the grave through a simple discretionary trust that allows the deceased’s pension fund to pass straight to their children, effectively bypassing the surviving spouse’s estate. Whilst the fund remains outside the surviving spouse’s estate they are still classed as a “potential beneficiary” and, as such, can receive loans from the trust which would then be allowable deductions for inheritance tax on their subsequent death.
At the very least if there is no trust in place ensure that any death benefit instruction held by a pension scheme is up to date. You wouldn’t knowingly entrust what happens to your home to a complete stranger. If there are no instructions in place you could be relying on a pension trustee to second guess your intentions.