Expats Pensions 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.”


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