New pension death options
Less tax and more choice! The new pension benefits rules will have individuals giving more thought on how they can provide a legacy from their remaining pension pot. The changes from 6 April will see pension pots become far more inheritable than ever before.
But prompt action may be needed to ensure individual’s wishes can be met before it’s too late. Many pensions have been around for years – designed with a very different retirement journey in mind and may not offer the new options.
Dying while stuck in a pension scheme which doesn’t offer the new freedoms or with an outdated death benefit nomination may be impossible to correct post mortem. Therefore it may be necessary to consider transferring existing pensions to more modern ones which are fully flexible
Death benefits changes – a double boost
There are two significant changes to defined contribution (DC) pension death benefit rules from 6 April. These will trigger the need for a rethink around how pension wealth is passed on, and what steps individuals should take to plan ahead.
- Who can benefit: Lump sum death benefits can continue to be paid to any nominated individual or trust. No change there. But the new rules no longer restrict a continuing pension income to a dependant. Pension savings can now be passed to any nominated individual (not a trust) to draw an income from, while remaining in a tax privileged pension wrapper via an inherited drawdown fund. 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. And they can nominate their own beneficiaries to inherit the pension pot on their death. This allows pension wealth to be cascaded down the generations, with fully flexible access, and without ever forming part of an estate until it is paid out.
- The tax they pay: 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 an LTA test against the latter).
- On death before age 75, any pension death benefits can be paid tax free. This includes any nominations in favour of a bypass trust.
- On death at 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. So, depending on a beneficiary’s tax status, benefits could be taxed anywhere between 0% and 45%. 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. Note that bypass trusts cannot be nominated for income, and so can only benefit from a lump sum, which will always be taxed at 45%.
- For individuals, the same tax treatment applies to both income and lump sums provided on death (For 2015/16 only, non-drawdown lump sums will be taxed at a flat rate of 45%).
So what will this mean for advice?
So much has changed that it will require a reassessment of what individuals would like to happen to their fund.
- Will it be better to leave pension wealth to family members via an inherited drawdown arrangement?
- Is a bypass trust still an attractive option for passing on pension death benefits?
The answer to these questions will of course come down personal circumstances. And the choice needn’t be ‘either or’. For example, an individual can request that part of their fund on death is nominated to certain family members for drawdown, with the rest paid into a bypass trust. But it helps to fully understand how the new rules could impact on the decision making process.
Under the pre 6 April 2015 rules only a dependant can carry on in drawdown following the death of the pension scheme member. But from 6 April it will be possible for anyone to be nominated to inherit the drawdown fund.
So for the first time pension wealth may 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 age 55 to access 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 CGT.
- The pension fund also remains outside the beneficiary’s estate for IHT and doesn’t count towards their own pension lifetime allowance (LTA). The fund can continue to remain in the pension wrapper even after the beneficiary’s death as they too can nominate a successor.
- 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.a) Where death occurred before 75 the beneficiary has pension pot which they can access at any time which is completely tax free.b) For deaths after 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 2015/16 tax year only, lump sum death benefits will be taxable at 45%. 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.
A popular way of passing on pension wealth tax efficiently has been the use of bypass trust. The pension death benefit lump sum is paid to a discretionary trust from which family members can benefit.
They are often referred as ‘spousal bypass’ trusts as one of the key benefits allowed the spouse access at the trustee’s discretion but without it forming part of their estate for IHT. While this has probably been the most common way that these trusts have been used, reference to ‘spouse’ is a bit of a misnomer, as access can be given to any of the trust beneficiaries with the same tax consequences.
But 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, a review of whether it is still appropriate going forward will be necessary. Where death is after age 75, the amount going into the bypass trust will suffer a 45% tax charge.
Capital distributions from the bypass trust are not taxable in the beneficiary’s hands. Although there may be an IHT exit charge to pay when capital leaves this trust. Trust IHT charges can be complicated, especially where it involves pension death benefits, and the trustees may require the help of a tax specialist which could incur additional cost.
Another feature often connected with bypass trusts is the possibility for the trustees to grant loans to a beneficiary. If the beneficiary spends the money, as would be anticipated when making the loan, the loan must be repaid from their estate on death, therefore reducing the beneficiary’s estate for IHT. A loan payment to a beneficiary is typically not taxable and would not be treated as an exit from the trust.
When comparing the merits of bypass trusts against inherited drawdown it is important to factor in that there will also be tax charges on both income and gains on the investments within the trust which would not arise if the money is retained within the pension wrapper.
However, tax isn’t the only motivation for using a bypass trust. Controlling who ultimately benefits from their pension wealth will be an important consideration for many clients. 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 the individual’s needs.
A bypass trust puts an individual’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 most 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 approved.
What needs to happen?
Individual awareness of the pension income changes may be high. But the same can’t always be said of the new death benefit options. It could even be the first time they have given any thought to what they could be leaving behind. For some it could mean they need to change their existing instructions. For others it may mean more drastic actions are required if the current pension doesn’t allow the preferred option.
Source: Standard Life