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AJ Bell: Time to fix holes in pension freedoms

JamesGareth

This autumn, for the first time in over six years, we look forward to dissecting the fresh ideas of a new Chancellor.

From a financial services perspective, many would argue George Osborne’s most important policy was the introduction of pension freedoms. It would be a surprise if Philip Hammond has any plans to roll back on those, particularly given their popularity with the grey vote.

It would be less of a surprise to see some of the wrinkles in the rules being tackled but it will be interesting to see whether Brexit reduces the resource available within HM Revenue & Customs to address them.

The haste with which the freedoms were introduced left several anomalies. Some of these have been dealt with already – for example, the issue preventing child dependants from continuing to receive death benefits once they reached 23. However, issues remain.

One of the most obvious also relates to death benefits and was recently described to me by one adviser as a “glaring hole in the rules”. It relates to the taxation of death benefits, specifically where the deceased was under 75 and their lifetime allowance has been used up. Let’s examine how the options open to beneficiaries are taxed.

The most obvious option for many beneficiaries will be to take a lump sum from the pension scheme as soon as it is available. If they receive the lump sum within two years of the death the payment is tested against the lifetime allowance and the recipient will face a 55 per cent tax charge.

Assuming the beneficiary is eligible to receive death benefits as a pension, the next option to consider might be to keep the funds inside a pension and draw an income over time. Again, this is tested against the lifetime allowance, provided the funds are designated to drawdown within two years. As the funds are kept inside a pension scheme the lifetime allowance tax charge is 25 per cent rather than 55 per cent.

While a member is still alive this difference between the 25 per cent and 55 per cent lifetime allowance tax charge makes some sense. If the member only keeps the funds in the pension and only pays the 25 per cent tax charge they will pay income tax on any pension they receive from the excess funds. Assuming they are a higher rate taxpayer, a 25 per cent lifetime allowance tax charge plus 40 per cent income tax on the benefits is roughly equal to the 55 per cent tax charge on the lump sum.

Unfortunately – or fortunately if the rules are used to minimise tax charges – the 25 per cent/55 per cent difference makes no sense in relation to death benefits where the deceased was under 75. This is because the beneficiary pays no income tax on death benefits moved into drawdown.

Using an extreme example, rather than choosing to pay a 55 per cent lifetime allowance charge on a single lump sum, the beneficiary could put the death benefits into drawdown, pay a 25 per cent lifetime allowance charge and then withdraw the entire pot as a single pension payment without paying one penny more in tax.

The tax anomalies become even more pronounced if death benefits are not paid out as a lump sum or designated as a pension within two years of the death.

A two-year delay in paying death benefits may not be something either the beneficiary or scheme administrator is willing to consider but, if funds are not designated within this period, there is no lifetime allowance test at all. Instead, assuming the beneficiary is an individual, they pay income tax on their lump sum or ongoing pension payments.

If the beneficiary chooses a lump sum and we assume the excess over the lifetime allowance is significant, it is likely the recipient will face income tax of 40 per cent on much of the lump sum.

Alternatively, if the pension option is chosen by the beneficiary, they have the opportunity to manage any income tax on withdrawals. Beneficiaries with no need for income from the pension benefits can leave them untouched to be passed on to future generations following their own death. If the beneficiary dies before age 75 then recipients will face no tax at all.

So we have a single set of circumstances that can result in some beneficiaries paying a 55 per cent lifetime allowance tax charge and others paying 25 per cent, while others pay income tax ranging from 40 per cent to nothing.

Based on the queries we are receiving, the reduction in the lifetime allowance is making this anomaly relevant in more and more cases. Given the most obvious option open to beneficiaries results in such a comparably poor outcome, it is hoped HMRC is given the time to come up with a solution.

Gareth James is head of technical resources at AJ Bell

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Comments

There are 2 comments at the moment, we would love to hear your opinion too.

  1. More reason to scrap the LTA now as it has all become very confusing for everyone – no wonder the BOE official said what he did a few months ago.

  2. HMRC has been aware of this anomaly from day 1. I wonder if it would deem an election to take a pre-75 death benefit excess as a nominee drawdown fund taxable at 25% then a single, full-fund withdrawal (tax-free), as an abuse of the rules as it intended them to apply?

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