The problem: The client is in drawdown, having taken his tax-free cash, but is not taking an income. The drawdown fund is subject to a 55 per cent tax charge on death. From an estate planning perspective, this is likely to be a very inefficient position to be in.
The client is a basic-rate taxpayer. He has a child who is a higher-rate taxpayer and would like to eventually leave his inheritance to his child.
The solution: If the client is not taking a pension income (or is not fully utilising any income), then this is a golden opportunity from an estate planning perspective. First, starting to take an income will move the money out of the 55 per cent taxed environment. Using the income to contribute towards his child’s pension can help boost his child’s inheritance by thousands:
For example, the parent takes £10,000 income from his pension. As he is a basic-rate taxpayer, he will receive £8,000 net income. This is then paid into the child’s pension.
The adult child is a higher-rate taxpayer so receives 40 per cent tax relief on pension contributions. The 20 per cent relief is available immediately, so £10,000 goes straight into the pension.
The child claims back the higher-rate relief (extra 20 per cent) through his tax return. HMRC sends child a cheque for £2,000 for child to spend as they wish.
The £2,000 cheque from HMRC is a real bonus – and the child can spend this money as they wish, it does not have to be paid into the pension. If the child has an unused Isa allowance, they may decide to put the money into a stocks and shares Isa to provide more immediate savings.
If the parent did this for 10 years and then they die, the child’s inheritance could be as follows:
The drawdown fund could grow from £300,000 to £361,000 over the 10 years. Lump sum after 55 per cent tax paid = £162,450. The child’s pension pot could be worth £135,700 after 10 years, plus the stocks and shares Isa could be worth £27,140. Total inheritance could be £325,290.
This is based on a 6.5 per cent growth rate, with an initial 3 per cent charge and 0.5 per cent trail.
Compare this with how the inheritance could have looked had no action been taken. The drawdown fund could have grown from £300,000 to 495,000, less 55 per cent tax = £222,750 inheritance,
so this action could boost the child’s inheritance by a staggering £102,540 (£325,290 – £222,750).
The longer this planning goes on for, the greater the benefit. As the pension fund cannot be accessed by the child until they reach age 55, there is less chance of the child frittering the money away. Plus, the money will stay locked away with the potential to grow.
As an added bonus for those at risk of losing child benefit from 2013, if the adult child has his own family and has an earnings level where there may be a risk of losing child benefit from 2013, this planning could have another added benefit.
The pension contribution is actually deemed to be made by the adult child and could help bring taxable earnings down to below the £50,000 adjusted net income threshold for child benefit purposes. This could mean an additional benefit of up to £1,055 more a year in child benefit – higher if the family has more than one eligible child.
Phil Carroll is head of financial planning at Skandia