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Are pension death benefits about to get a new lease of life?

In the wake of the Chancellor’s sweeping changes to annuities, speculation is growing that the Government’s Autumn Statement will transform the way pension benefits are taxed after death 

When the Government publishes its Autumn Statement on 3 December, we should know the rate of tax that will be payable on lump-sum death benefits from April 2015. If it is reduced from 55 per cent, people will be handing more of their pension pots down to beneficiaries and less to the taxman. But given the changes being made in the new era of pension freedoms, could more radical changes lie ahead to make it easier to pass on pensions upon death?

Rowanmoor Group head of pension technical services Robert Graves wonders whether the Government has delayed announcing its plans because it intends to go further than reducing the tax charge on death benefits. 

He says: “My hope is that the Goverment will do something more radical. It could be that they are examining inheritance tax and the taxation of pension death benefits could be a small part of that. 

“Why not allow people to pass on the wealth they have accrued by saving for their retirement? Ultimately that would help the next generation be less reliant on the state.”

Rules

There are already various ways to pass pension benefits on after death under current rules but the options and tax treatment of those options depends on the type of pension, the age of the pension holder at death and whether benefits have been taken from the pension.

If someone dies before taking their pension, a lump sum may be paid to their beneficiaries but tax liability depends on the age of the pension holder at death. 

If they die before age 75, the lump sum can be paid tax-free provided it falls within their lifetime allowance – currently £1.25m. Amounts above the lifetime allowance will incur a 55 per cent tax charge, as will death at age 75 and above.

If someone dies after taking their pension benefits, death benefits will depend on either their defined benefit scheme rules, the type of annuity they bought and whether options such as spouse’s benefit were selected at the outset or whether they were in drawdown. 

Any lump-sum payments made to beneficiaries would be subject to the 55 per cent tax charge regardless of age.

Suffolk Life pension technical manager Paul Evans points out that inheritance tax can be mitigated in relation to pensions by not taking benefits, gifting to dependants or using a bypass trust. 

“A spousal bypass trust is a way of ringfencing dependants’ benefits paid on death. It’s a separate trust arrangement that has its own nil-rate band, so it is taken out of the estate and not measured against the originator’s IHT liability,” he says.

Evans points out that a spouse can be named as a trustee and is allowed to take loans from the trust. “But these trusts needs legal assistance to set up and there are also cost implications,” he says.

Law firm Access Legal senior associate in wealth protection Jane Whitfield believes  the existing ways to pass on pension benefits after death and mitigate inheritance tax could mean a lack of appetite for changing the existing rules. 

She adds there are a large number of variables to consider, with definitions of terms such as “dependant” and the benefits to be paid varying from scheme to scheme. “It would take a wholesale review of the way pension schemes are established and managed to enable pension benefits to be passed on after death on a general basis,” she says.

Changes

Graves feels something needs to change because it is illogical that different tax rates depend on whether benefits have been taken and whether someone has reached 75 or not. He thinks simplifying the taxation of death benefits would also simplify the advice process and encourage more people to save for their retirement.

Passing a pension on after death in the simplest sense of enabling your children to start or bolster their own pension may sound like a good idea for several reasons. 

It could encourage people to keep money in the pension system rather than taking it out when they reach 55 under the new regime. It could incentivise people to save and encourage more financial planning.

Aegon UK regulatory strategy manager Kate Smith thinks the idea could work as long as the inherited pension was kept within a pensions wrapper; was ringfenced so that a 25 per cent tax-free lump sum could not be taken more than once and was taxed.  

“This could be something the Government might want to look at but I expect they would want to take their cut and put a tax charge on it,” she says.

Tax

The way pensions work – by incentivising people to save through tax relief on the way in, while being taxed on the way out – makes inheriting a pension tax-free unlikely.

Towry head of retirement planning Andy James says: “Pensions are basically set up as a tax deferment vehicle. Apart from the tax-free cash element, they allow an individual initial tax relief on contributions on the understanding tax will be paid either when funds are later withdrawn as income, or on death.

“If the rules are changed to allow funds to remain in the pension on death, potentially for generations, and to be inherited as a pension, the Exchequer will be forgoing a significant tax take, which I am not sure they or the country as a whole could afford at this time.” he says.

Prydis Wealth director Scott Harrison agrees. “There would be an imbalance if a pension wasn’t taxed on death,” he says. 

“People are incentivised to save in a pension because of the tax relief and opportunities to take benefits, like a tax-free lump sum. I rationalise it by thinking if pensions were not taxed, the Government wouldn’t be able to recover the tax relief and would have to recover the money from something else.”

For James, defined benefit pensions could also cause problems. “It would seem a bit unfair if defined contributions could be passed on but defined benefit could not. However, I don’t think that these schemes would survive without the current level of cross-subsidy that goes on from the early death of some members,” he says.

Encouragement to save

Both Graves and Aspire to Retire principal Rob Tinsley point out it is possible to include children as part of a self-administered personal pension or small self-administered scheme. This can be helpful in succession planning for small, family-run businesses.

But Tinsley does not think allowing this generally within a pension would encourage people to save more in a pension, because they are already struggling to build a decent pension for themselves.

St James’s Place Wealth Management’s divisional director  for pensions Ian Price says: “Passing it down is a ‘nice to have’ but most people haven’t got a big enough pension fund.”

However, London School of Business and Finance (LSBF) CFA programme director Graham McDonald says that not having to buy an annuity at 75 from April 2015 will result in more people taking drawdown and potentially having a surplus that can be passed on rather than it going to annuity providers. “This could provide very significant opportunities for advisers,” he says.

TAXATION OF LUMP SUM DEATH BENEFITS

Pension benefits not taken (uncrystalised)

  • Death before age 75: No tax charge on lump sums below £1.25m lifetime allowance, 55 per cent on portion above lifetime allowance
  • Death age 75 and over: 55 per cent tax charge

    Pension benefits taken (crystalised)

  • Death before age 75: 55 per cent tax charge
  • Death age 75 and over: 55 per cent tax charge 

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Comments

There are 3 comments at the moment, we would love to hear your opinion too.

  1. Other than the relatively tiny amounts of lost tax, I don’t see why there should be any barriers to the government allowing unspent funds to pass down (tax free) directly into PP’s for the next generation. Such a move would surely chime with the government’s claimed wish to encourage saving for retirement. Even Steve Webb might get with the idea.

  2. I admire the optimism. I cannot be alone in thinking that a major motivator behind the announcement of the brave now world of pensions was an anticipated increase in tax revenues…and we’re now hoping this government will feel moved to do something that will reduce these?

    I hope to be proved a miserable curmudgeon.

  3. I agree Andy. I suspect that any generosity in reducing the tax on post crystalistion lump sum death benefits is likley to be balanced by an increase in the tax on pre crystalisation lump sum death benfits.

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