Pension Succession Planning Guide To Passing On Your Pension
On 6 April 2015 there were sweeping changes to the way in which pension funds can be distributed after a member’s death.
Pension savings can now be passed on to any nominated individual to draw an income from, while remaining in a tax privileged pension wrapper.
Once a drawdown fund has been created for a nominated beneficiary, they can access the pot at any age, drawing as much or as little as they choose.
They can even nominate their own beneficiaries to inherit the pension pot on their death meaning a pension can now truly be passed down the generations.
This guide will explore how pension wealth can be cascaded down through a family, with fully flexible access, and without ever forming part of an estate until it is paid out.
Different options for passing on your pension are explored as well as the impact on these tax changes on the attractiveness of this wrapper versus other assets such as buy-to-let.
Supporting material produced by David Downie, technical consultancy manager of Standard Life, Gareth James, head of technical resources at AJ Bell, and Sandra Hogg, senior tax and financial planning manager of Scottish Widows.
Tax Rules For Passing On Your Pension
There are two significant changes to defined contribution pension death benefit rules from 6 April 2015.
There are two significant changes to defined contribution pension death benefit rules from 6 April 2015.
Firstly, in terms of who can benefit, pension income can now be paid to any nominated individual. Secondly, the tax they pay has changed. Where the deceased is aged less than 75 and the death benefits are designated to a beneficiary within a two-year period, benefits will be paid free of tax.
Where the deceased is over the age of 75, benefits will be subject to tax.
The tax rate that applies will be the beneficiary’s personal/marginal rate of income tax, unless the death benefits are paid out in the form of a lump sum before 6 April 2016, in which case the benefit is liable to 45 per cent tax.
A tax bill will occur if the death benefits are not designated within two years and are from uncrystallised funds.
If the death benefits are not designated within two years and are from crystallised funds where the member was under 75 they will not be subject to tax where taken as a beneficiary’s drawdown pension.
On the death of a beneficiary remaining funds can be passed on again, and it is the age of the beneficiary at date of death that dictates whether funds are taxable, not the age of the original member.
Any dependent’s pensions that are in payment at 5 April 2015 will continue to be taxed.
There will be a new benefit crystallisation event where uncrystallised funds are designated for a dependent’s or nominee’s flexi-access drawdown pension within two years of the member’s death.
Three separate classes of beneficiary will be able to receive pension income from the deceased member’s fund: dependent, nominee, and successor.
If a beneficiary does not fall into one of these classes of beneficiary, they will not be able to receive death benefits as a pension. These classes are not relevant to receipt of lump sum death benefits. There are no restrictions on the type of beneficiary who can receive lump sum death benefits.
A dependent is defined as someone who was a dependent of the original scheme member at the time of their death.
A dependent is a spouse, civil partner, child under the age of 23, an older child who was dependent due to physical or mental impairment, someone who was financially dependent on the member, or someone in a financial relationship of mutual dependence with the member.
A nominee can be anyone nominated by the member. A successor can be anyone nominated by a dependent, nominee or successor to receive any remaining benefits on their death.
There is no limit on the number of successors, so in theory the fund could be passed on for generations if it is not all taken out. The scheme administrator has discretion as to how any death benefits are paid, and can make lump sum death benefit payments to any individual.
Following the death of a member who has not made a nomination and does not have any dependents, the scheme administrator can nominate a nominee to receive an income from the fund.
Following the death of a dependent, nominee or successor who has not made a nomination, the scheme administrator can nominate a successor to receive an income from the fund.
Alternatively, if there are any surviving dependents of the original member, the scheme administrator can use its discretion to pay death benefits to them.
The tax rates covered are in addition to any lifetime allowance charge that can apply where an individual’s total benefits exceed the allowance (currently £1.25m).
A lifetime allowance excess is charged to tax at a rate of 55 per cent if the excess is paid out as a lump sum or 25 per cent if designated for flexi access drawdown, or used to buy an annuity.
David Downie, technical consultancy manager of Standard Life, says these tax changes will trigger the need for a rethink around how pension wealth is inherited going forwards.
He says it is vital advisers remember, although the new rules can be applied to all defined contribution pensions, not every defined contribution pension scheme will have the systems in place to offer them.
For example, Mr Downie says there will be a number of older schemes which cannot offer inherited drawdown and the only income option for someone dying in such a scheme may be an annuity.
He says the changes do not affect those with a defined benefit pension plan.
And while similar changes have been made to the death benefit rules for annuities, Mr Downie says it typically remains a decision which needs to be made at the time the annuity is
Different Ways To Pass On Your Pension
Insurance-based pension products usually offer two main types of pension death benefit: lump sums and beneficiary drawdown.
The key decision faced now is whether to take any remaining fund on death as an income or as lump sum.
Insurance-based pension products usually offer two main types of pension death benefit: lump sums and beneficiary drawdown. Some providers may also offer dependent’s annuities. Where beneficiary drawdown is made available by the provider, it is usually seen as the default choice.
But David Downie, technical consultancy manager of Standard Life, says it is worth remembering that if taken as a lump sum and it is outside the pension wrapper, it may form part of the beneficiary’s estate for inheritance tax purposes.
It is now possible for pension wealth to be passed to adult children within the pension wrapper, rather than as a lump sum. And there is no requirement for them to wait until they reach the age of 55 to access the income from it.
The tax benefits of this option are threefold:
- The fund remains invested in tax free environment with income and gains free from income tax and capitals gains tax;
- The pension fund also remains outside the beneficiary’s estate for inheritance tax and doesn’t count towards their own pension lifetime allowance. The fund can continue to remain in the pension wrapper even after the beneficiary’s death as they too can nominate a successor; and
- The tax on income withdrawals is determined by the deceased’s age on death.
So initially, it will be the age of the member at date of death that determines how their beneficiaries are taxed. Subsequently, it will be the age at death of the beneficiaries that determines how their chosen successors are taxed. And so on.
Where death occurred before the age of 75, the beneficiary has a pension pot which they can access at any time which is completely tax-free. For deaths after the age of 75, withdrawals will be taxable at the beneficiary’s marginal rate.
But unlike taking a lump sum, the beneficiary may be able to limit the tax payable if withdrawals are taken over an extended period rather than the whole amount taxed in a single year.
For the 2015 to 2016 tax year only, lump sum death benefits will be taxable at 45 per cent. However, if inherited drawdown is taken, the beneficiary can still take the whole fund as income and it would then be taxed at their marginal rate.
Sandra Hogg, senior tax and financial planning manager of Scottish Widows, says a lump sum death benefit may be preferable where the beneficiary is not concerned about inheritance tax and does not want the benefits to be passed on to a subsequent beneficiary via the pension scheme i.e. they want to either spend the money or pass it on via their will.
She says the lump sum option will also be required where the death benefits are to be directed to a pilot trust such as a bypass trust. The pension death benefit lump sum is paid to a discretionary trust from which family members can benefit.
They are often referred to as ‘spousal bypass’ trusts since a spouse is allowed access at the trustee’s discretion without it forming part of their estate for inheritance tax.
But Mr Downie says it is worth noting that access and the ability to keep the funds outside the spouse’s or any other beneficiary’s estate will be mirrored through the new inherited drawdown.
If this was the primary purpose of setting up the bypass trust, Mr Downie says a review of whether it is still appropriate going forward will be necessary.
Where death is after the age of 75, the amount going into the bypass trust will suffer a 45 per cent tax charge. When money is paid out from the trust to a beneficiary, it will become treated as income with credit given for the tax already deducted.
When comparing the merits of bypass trusts against inherited drawdown, Mr Downie says it is important to factor in that there will also be tax charges on both income and gains on the investments within the trust. This would not arise if the money is retained within the pension wrapper.
And of course if the trust has already suffered a 45 per cent tax charge upfront, Mr Downie notes it would have a significant impact on future investment returns. However, he says tax is not the only motivation for using a bypass trust. Controlling who ultimately benefits from their pension wealth will be an important consideration for many clients.
Mr Downie says: “These two factors are at the heart of effective wealth transfer planning, to ensure accumulated wealth passes to loved ones and future generations in a way which meets customer needs.
“A bypass trust puts a client’s own chosen trustees in charge over who benefits, and when. The trustees can be guided in the decision making by a letter of wishes from the deceased.
“This control from ‘beyond the grave’ may be a comfort for complicated family structures or where there are children from previous relationships.
“Inherited drawdown will in many circumstances provide more tax-efficient and simple wealth transfer options than a bypass trust, but the inherited fund could be withdrawn and spent by the nominated individual, or ultimately nominated to another successor whom the original member would not have
Tax Implications Of Inheriting A Pension
There is no longer any taxation distinction between benefits provided from crystallised and uncrystallised funds.
Age at death now determines the tax treatment of pension death benefits.
There is no longer any taxation distinction between benefits provided from crystallised and uncrystallised funds (other than the need for a lifetime allowance test on uncrystallised funds).
On death before the age of 75, any pension death benefits can be paid tax-free. This includes any nominations in favour of a bypass trust. On death after the age of 75, the beneficiary pays income tax on the money they draw, whether this is taken all in one go, or as a series of income payments.
David Downie, technical consultancy manager of Standard Life, says depending on a beneficiary’s tax status, benefits could be taxed anywhere between 0 per cent and 45 per cent.
He says careful planning on how much income to take each year, in conjunction with income from other sources, can therefore minimise the tax that has to be paid. Bypass trusts can only benefit from a lump sum, which will always be taxed at 45 per cent.
But new rules will allow the bypass trust beneficiaries to have payments from the trust treated as income with credit given for the tax already deducted.
For individuals, the same tax treatment applies to both income and lump sums provided on death (For 2015 to 2016 only, non-drawdown lump sums will be taxed at a flat rate of 45 per cent).
Sandra Hogg, senior tax and financial planning manager of Scottish Widows, says the new options for passing on pension death benefits under the pension freedoms rules do offer some potential advantages compared with, say, investing in a buy-to-let property.
In particular Ms Hogg highlights where the payment of death benefits is tax-free because the member or previous beneficiary died before reaching age 75.
She points to an example where Andy dies leaving investments in buy to let property worth £1m, while Betty dies before age 75 leaving an uncrystallised pension fund of £1m.
They both have other assets worth more than £325,000 (the current inheritance tax nil rate band. Andy’s investment properties fall into their inheritance tax estate. If his spouse or civil partner inherits, so he makes an exempt transfer, there’s no inheritance tax to pay on his death. However, the value of the investment properties increase the inheritor’s inheritance tax estate by £1m.
So Ms Hogg says it is more likely that inheritance tax will be payable on their death as the new residence nil rate band won’t be available to set against investment properties.
If Andy leaves the investment properties to a non-exempt beneficiary – such as a co-habitee, his children, or a discretionary trust – there will be an inheritance tax charge of £400,000 on this part of his estate.
Ms Hogg says this could reduce the value of this inheritance to £600,000 unless he has sufficient life cover written in trust to cover the inheritance tax liability.
Once inherited, she says the investment returns on buy-to-let properties are subject to income tax (for rental income) and capital gains tax (on disposal) – although at least the CGT base cost is the market value as at the date of Andy’s death.
There are also the costs of letting out the properties to take into account.
If Betty nominates her spouse or civil partner to receive her death benefits, and the scheme administrator exercises its discretion to set up flexi-access drawdown, Ms Hogg says there is no inheritance tax to pay.
If the death benefits are covered by Betty’s available lifetime allowance, Ms Hogg says the full fund is available and can be accessed without any income tax charges. However, Ms Hogg says if the full fund is withdrawn it will then be within the recipient’s estate for inheritance tax purposes. This also applies if Betty nominates a cohabitee, or her children or grandchildren and they benefit from flexi-access drawdown.
So whoever the beneficiary is, Ms Hogg says they could inherit the full £1m.
If Betty has no available lifetime allowance at all as at the date of her death, Ms Hogg says there would be a tax charge of 25 per cent on £1m, so the beneficiaries would still inherit £750,000 on designation for flexi-access drawdown.
When the original beneficiary dies, they can nominate a successor to continue to receive beneficiary flexi-access drawdown.
The funds are not in the beneficiary’s inheritance tax estate while they remain within the pension environment and have no effect at all on their own lifetime or annual allowances in respect of their own pension funding. So Ms Hogg says the full amount left over can be inherited by the next generation.
If the original beneficiary dies under the age of 75, withdrawals continue to be tax free, although they are taxable if they die age 75 or over. Once inherited, the funds remain invested in a tax advantaged pension environment.
Ms Hogg says: “There are the costs of running a flexi-access drawdown to take into account.
“And if the death benefits are taxable because the member or previous beneficiary died after reaching age 75, then the death benefit tax charges on the recipient must be taken into account.”
Best Advice On Passing On Your Pension
Time for you to review who you have nominated for death benefits.
The rule changes are significant so it may be appropriate for you to review who they have nominated to receive death benefits.
Gareth James, head of technical resources at AJ Bell, says it is also important that any clients in receipt of a dependent’s pension make a nomination, as there is now far greater flexibility in terms of how funds remaining on their death are distributed.
It may also be the case that in the future some clients may wish to change their nomination on their 75th birthday if they are concerned about passing funds on in the most tax-efficient way.
For example, Mr Smith dies at aged 80 with a substantial pension fund. He has the following family: Mrs Smith, wife, 72, basic rate taxpayer; Janet, daughter, 50, higher rate taxpayer; John, son, 47, higher rate taxpayer; Adam, grandson, 20, non-taxpayer; Bella, granddaughter, 18, non- taxpayer; Charlie, grandson, 12, non-taxpayer and Darcy, granddaughter, 9, non-taxpayer.
Mr Smith wants to ensure his wife has sufficient funds to live on after his death, but as his fund is substantial he does not believe she would need the entire fund to live comfortably for the remainder of her life.
He wants to pass his fund on in a tax-efficient manner. He therefore completes an expression of wish leaving 60 per cent of his fund to his wife, and 10 per cent to each of his grandchildren. When he died, Mr Smith was over 75, meaning any benefits paid out are taxable at the recipient’s marginal rate.
Mrs Smith will therefore pay basic rate tax at 20 per cent (provided she doesn’t take income above the threshold for higher rate tax).
As non-taxpayers with no other income, each of his grandchildren can take up to £10,600 out each year without paying any tax.
There is no requirement for them to take any income if they do not need it. If they did become higher rate tax payers in the future they could opt to leave the money in a pension even until their retirement when their tax rate may drop.
Unfortunately, Mrs Smith only lives for another two years following her husband’s death. She has nominated her two children, Janet and John, to be the beneficiaries of the fund on a 50/50 basis.
As Mrs Smith is only 74 at the time of her death, Janet and John can take the benefits out free of income tax, despite the fact the funds originated from Mr Smith.
Had Mrs Smith lived beyond age 75, AJ Bell’s Mr James says she may have considered reviewing her nomination if she believed her children did not need the entire fund and she was concerned about passing funds on in a tax-efficient manner.
She may have found it appropriate to allocate some of the funds to her grandchildren and, if great-grandchildren had arrived, to them also, Mr James adds.
When making nominations Mr James says one of the key points to bear in mind is that the scheme administrator can only nominate a non-dependent beneficiary to receive the benefits as flexi-access drawdown where the deceased has not nominated anyone.
Dependents of the original member can receive benefits as flexi-access drawdown regardless of whether they were nominated by the deceased.
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