Pensions – the latest tool for tax planning?

August 26, 2015

Although pensions usually fall outside the scope of Inheritance Tax, until recently they did incur a ‘death tax’ under certain death benefit rules. The loophole caught people out where the member was either over 75 years old or had started to draw on their pension before they turned 75. In either of these scenarios, the member’s nearest and dearest would have been saddled with a very hefty tax bill of more than half the value of the fund. So it’s no wonder that many people shy away from using pensions as a way to pass on wealth to the next generation.

However, wide-ranging reforms introduced from 6 April mean that for the first time there is now greater opportunity for an entire pension pot to be passed down to future generations (or other named beneficiaries) potentially free of tax.

Under the new rules, if the pension fund holder dies before they reach 75, a beneficiary can inherit some or all of the fund as a lump sum, or they can take income from drawdown. This would be tax free up to the Lifetime Allowance (currently set at £1.25m).

If the pension fund holder dies on or after their 75th birthday, any beneficiary receiving a lump sum will pay 45% tax until next April if the fund is paid as income, not a lump sum. However, after 6 April next year, the pension pot that is inherited will be taxed at the recipient’s marginal rate, which could well be less than 45%, thus saving significant tax.
These reforms are likely to change the way in which people tap into their assets in retirement. In the past, the advice has often been to take funds out of a pension as quickly as possible prior to the member’s death, in order to avoid the tax charges which previously applied.

The ability to roll-up funds free of tax within the pension pot, coupled with the ability for the member’s beneficiaries to take money out by way of income draw down over a period of time either tax free (if the member has died under 75) or at the beneficiary’s own tax rates (if the member has died over 75) without the additional tax charges which previously applied, may well mean that it is now better to leave as much in the pension pot as possible for as long as possible.

It has been fairly standard practice until now, for people under 75 to arrange for any lump sum death benefits to be paid into a discretionary trust. However, in light of the new rules, this should be reconsidered. Taxation of discretionary trusts has been a key objective of successive governments for a number of years with the result that these types of trusts are taxed at the higher rate and also incur additional charges every 10 years. On the other hand, they can be very effective both in respect of protecting family wealth against third party claims such as divorce and bankruptcy as well as generational tax-planning. For example, if pension funds are held in a separate discretionary trust, the trustees can make loans to the beneficiaries. These loans will then become deductible from that beneficiary’s estate for inheritance tax purposes, thus passing through the generations in a tax-efficient way.

As to which is the best solution for any pension fund, the answer is clearly to review your current strategy in light of these changes and seek professional advice sooner rather than later.

The contents of this article are intended for general information purposes only and shall not be deemed to be, or constitute legal advice.