Death Benefit update

The Freedom and Choice pension reforms first announced in Budget 2014 have greatly changed how pensions can be utilised in financial planning.

Greater access flexibility means savers can now use their pensions for far more than a retirement income.

In addition changes to the way death benefits are taxed opens yet more opportunities for pensions to be passed on and used within financial planning.

The knife-edge

Historically, the tax position of a lump sum death benefit depended on whether the fund had been ‘crystallised’ or not, which broadly meant once a pension-commence lump-sum (PCLS) had been taken the death benefits would be poorer. For example, an individual aged 60 at death could leave their uncrystallised Personal Pension fund to a dependant free of tax, but if they also held a drawdown plan this would attract a tax charge of 55% (the special lump sum death benefit charge).

Under the new rules, the main factor is the age of the member. Where the member dies under age 75 the benefits can generally be paid free of tax to a chosen beneficiary (with some restrictions, discussed later). For members aged 75 and above, income paid will be taxed at the beneficiaries marginal rate and lump sums taxed at 45% in 2015/16.

Who can benefit?

The Taxation of Pension Act 2014 introduces two new types of beneficiary drawdown, giving three types:

  • 1. Dependants flexi-access drawdown;
  • 2. Nominee flexi-access drawdown;
  • 3. Successor flexi-access drawdown.

On death of the member where the beneficiary wants to draw an income, the fund will enter either dependants drawdown or nominee drawdown – depending on whether the beneficiary is a dependant or not (i.e. a dependant cannot use nominee flexi-access drawdown). On second death the fund will become successor flexi-access drawdown, and remain successor flexi-access drawdown through subsequent beneficiaries.

A nominee for the purposes of nominee flexi-access drawdown includes any non-dependant that has been nominated by the member, and any non-dependant nominated by the scheme if the member did not nominate a beneficiary (individual or charity).

However, the scheme cannot nominate anyone for nominee flexi-access drawdown where a dependant of the member is alive. For example, where a dependant spouse exists the scheme cannot nominate non-dependant children to receive the income, but could choose to pay a lump sum benefit although this could attract a higher rate of tax (discussed later).

A nomination means a beneficiary nominated via an expression of wish or by binding direction, where scheme rules permit and/or circumstances dictate. There has been no change to the scope of existing inheritance tax rules that affect when a pension fund will be counted in the deceased estate. Generally, where the scheme member can bind the trustees to pay to a specified beneficiary, who is not a dependant, it is within the deceased estate, but where there is discretion it is not within the estate. Most schemes operate on an expression of wish basis with the scheme administrator making the final decision, although some do call this a nomination of beneficiary.

What is the tax position?

The tax paid will depend on:

1. Age of the member at death;
2. Crystallisation status of the funds at death (for lifetime allowance excess purposes only);
3. If the benefit is paid within the relevant two year period starting with the scheme being notified of the death (or could have reasonably known of the death)

There are three possible outcomes:

  • Tax-free: no tax is to be deducted from the payment.
  • Marginal: the beneficiary will be liable for tax at their marginal rate on the amount withdrawn.
  • 45%: The special lump sum death benefit charge has been reduced from 55% to 45%. It is intended that this will move to marginal rate in future and, in the meantime, entering beneficiary flexi-access drawdown and taking the balance as income would be favourable where allowed.

 

Pre-75

Generally, where death occurs pre-75 the beneficiaries can access the fund tax free; however this is only true where the benefits start to be taken within two years of notifying the scheme of the death (the ‘relevant period’). Benefits taken as income after this period has elapsed are subject to marginal rate income tax and lump sums are subject to 45% tax.

Both income and lump sum benefits taken within the relevant period are tested against the lifetime allowance, currently £1.25m.

 

Post-75

However, we would expect clients to survive past their 75th birthday. In this case tax is either payable at the marginal rate, where taken as income, or at 45%, where taken as a lump sum. The two year period will have no impact on the income tax position, and there will be no lifetime allowance test.

Types of payment

It is through the operation of a number of different types of payment that the above distribution and tax comes about. The differing types of payment available on death are summarised below for reference.

 

Uncrystallised Funds Lump Sum Death Benefit

A payment from uncrystallised pension monies within two years of being notified of the death of the member. The full value of the assets at the time of making the payment can be paid.

 

Drawdown Pension Fund Lump Sum Death Benefit

A payment made from capped drawdown on death of the member, or from dependants capped drawdown on death of the dependant.

 

Flexi-Access Drawndown Fund Lump Sum Death Benefit

A lump sum payment made on death of the member (or their beneficiary) from a Flexi-access drawdown plan, that is not a charity lump sum death benefit.

 

Trivial Commutation Lump Sum Death Benefit

Where a beneficiary is entitled to a payment of up to £30,000 from a scheme this can be taken as a trivial commutation lump sum death benefit. It must extinguish all of the rights under the scheme, both to an income and lump sums.

This includes payments from an annuity under a guarantee period where the value is less than £30,000.

 

Annuity Protection Lump Sum Death Benefit

A lump sum death benefit is an annuity protection lump sum where it is paid in respect of a scheme pension or a lifetime annuity, arranged from a money purchase pension.

The maximum that can be paid is the purchase price of the annuity less any gross income paid and less any other annuity protection sum lump already paid in respect of this annuity.

 

Charity Lump Sum Death Benefit

Where there are no dependants of the member alive a charity lump sum death benefit may be given. It must normally be paid from drawdown funds (member or a beneficiary) however where the member was aged over 75 and remained uncrystallised it can also be paid.

This prevents a charity lump sum being given directly where the member died unvested and under 75 years old, however a nominee or successor may elect to give a charity lump sum on their death.

 

Defined Benefit Lump Sum Death Benefit

A lump sum paid in respect of a defined benefits arrangement where the member was aged 75 and above, or if younger the payment was not made within the relevant two year period.

 

Pension Protection Lump Sum Death Benefit

Similar to an annuity protection lump sum death benefit but in respect of a scheme pension from a defined benefits arrangement. Where the member asks, and the scheme agrees, this would allow a sum up to the crystallisation amount less income received to be paid to the beneficiary.

Case Studies

A – down the generations

Problem: Billy and Mary were married for many years and have raised several children, some of whom have children of their own. Billy ran his own business for most of his life and built up a personal pension which he designated to capped drawdown when he retired two years ago. He then designated to flexi-access drawdown April 2015 at which point he completed an expression of wish in favour of Mary.

Sadly, Billy dies January 2016 aged 65 and Mary would like to know what the future holds for her income, and her late husbands’ pension fund. Mary is also concerned about how the fund will be treated on her death, whenever that may occur.

Solution: As Mary was nominated by an expression of wish the pension scheme will not be forced into paying to her but where there are no compelling circumstances to pay to someone else it is likely they will choose Mary to receive the benefits. As Billy died aged under 75, Mary has the following choices:

1. Enter dependant’s flexi-access drawdown within the relevant two year period and draw a tax-free income from the plan;
2. Enter dependant’s flexi-access drawdown after the two year period and receive an income taxed at marginal rate;
3. Take a flexi-access drawdown lump sum death benefit, which will be paid tax-free;
4. Buy an annuity or scheme pension.

As there are dependants of the member alive (Mary and her children) a charity lump sum death benefit would not be possible. For the same reason it would also not be possible for the scheme to nominate a non-dependent to receive any income (although the scheme could elect to pay a lump sum to a non-dependent).

Mary chooses flexi-access dependants drawdown and makes her decision within two years of notifying the scheme of Billy’s death, giving her a tax-free income for life. She immediately completes an expression of wish in favour of her children. Mary survives until she is in her 90s.

On her death the scheme, having considered all the potential beneficiaries, offer her beneficiaries the following choices:

1. Enter successor flexi-access drawdown and receive an income taxed at marginal rate;
2. Take a flexi-access drawdown lump sum death benefit, which will be taxed at marginal rate (assuming the post 2015/16 change to lump sum tax occurs)

Mary’s children may wish to consider the size of the remaining fund and the impact this would have on their tax position if taken as a lump sum. Additionally, funds within successor drawdown remain out of the estate for IHT purposes, unless a binding nomination in favour of a non-dependant is made.

The children nominate the pension to go to a named charity on their death. The scheme can choose to follow this nomination, or they can pay a flexi-access drawdown lump sum to another beneficiary (but they couldn’t set up successor drawdown due to the nomination in favour of a charity). Alternatively, they could have nominated their own children and continued to cascade this down through the generations.

 

B – A modern family

Problem: Mike and Sue (both aged 57) are married but separated and have been living apart for the past year. They have grown-up children who are non-dependant. In June 2015 Mike died, unexpectedly. He had not expressed a wish to the scheme for who should benefit in the event of his death.

Solution: Sue, although estranged, is still a dependant of Mike and therefore qualifies for dependants’ flexi-access drawdown. She would also be eligible for a lump sum payment. As Mike was aged less than 75 when he died any lump sum would be tax-free and (subject to the two year rule) income would be tax-free too.

The scheme would not be able to nominate Mikes children to receive an income from nominee flexi-access drawdown. Where no nomination has been made by the member to the contrary, nominee flexi-access drawdown cannot be set up for any non-dependant of the member while a dependant is alive. However, the scheme could choose to pay a lump sum benefit to the children, which could be paid tax-free as mike was aged less than 75 (however it would then form part of their estate).

This illustrates the importance of valid and up to date nominations to ensure that death benefits can be distributed in the most efficient manner, and provide beneficiaries with all the options.

Trusts

Under the current regime it is not uncommon to use a discretionary trust as the recipient of death benefits to ensure the monies stay outwith the estate of the intended beneficiary.

Future Developments

As mentioned above, the rate at which the special lump sum death benefit is charged may change in future. Currently this is set at 45% regardless of who the beneficiary of the payment is but in future the Government intend this to be at the marginal rate of the beneficiary. In practice, this change will mean little as most have the option of entering drawdown with the fund before taking an income of 100% of the balance – producing a lump sum subject to marginal rate. Payment out to a spousal bypass trust will remain largely unaffected as the marginal rate of the trust will remain 45%, for the majority of the payment.

 

Conclusion

Pensions are now perhaps the most tax efficient vehicle for passing wealth down through generations, the lack of tax on passage combined with the tax-free growth means even if subject to income tax in the hands of the beneficiary it may still be attractive.

While some may find their family situation demands greater control of the proceeds; most may be content to allow the funds to remain within the wrapper as long as possible.

It has been discussed elsewhere that pensions may be the new ‘first port of call’ for savings goals post age-55 and these changes strengthen the view that pensions could also form part of all good IHT planning.

 

Age at death Paid from Benefit Type Relevant Time Tax Subject to LTA ? BCE
< 75 years Crystallised Income < 2 years Tax Free No N/A
< 75 years Crystallised Lump Sum < 2 years Tax Free No N/A
< 75 years Uncrystallised Lump Sum < 2 years Tax Free Yes BCE-7
< 75 years Uncrystallised Income < 2 years Tax Free Yes BCE-5C
< 75 years Crystallised Income > 2 years Marginal No N/A
< 75 years Uncrystallised Income > 2 years Marginal No N/A
< 75 years Crystallised Lump Sum > 2 years 45% No N/A
< 75 years Uncrystallised Lump Sum > 2 years 45% No N/A
=> 75 years Crystallised Income < 2 years Marginal No N/A
=> 75 years Crystallised Income > 2 years Marginal No N/A
=> 75 years Uncrystallised Income < 2 years Marginal No N/A
=> 75 years Uncrystallised Income > 2 years Marginal No N/A
=> 75 years Crystallised Lump Sum < 2 years 45% No N/A
=> 75 years Crystallised Lump Sum > 2 years 45% No N/A
=> 75 years Uncrystallised Lump Sum < 2 years 45% No N/A
=> 75 years Uncrystallised Lump Sum > 2 years 45% No N/A

 

 

Source:  Darren McAinsh – Prudential