Wealth cascading down the generations: that is the vision for estate planning using the new pensions rules. So what are the new opportunities and, just as critical, what are the chances of their lasting long enough to be of practical help to clients and their families?
The opportunities come from the new rules about the tax treatment of pension death benefits after 5 April. If a pension scheme member dies before the age of 75, the death benefits will be tax free, regardless of whether a beneficiary takes them as a lump sum or as an income. That is, free of both income tax and inheritance tax.
What’s more, the value of the inherited death benefits will not eat into the beneficiary’s right to build up his or her own pension benefits.
Receiving a tax-free income from a deceased person’s pension pot – for life – sounds like a very attractive proposition, especially as it is derived from a more or less tax-free fund. It is just like receiving an instant Isa – one that in many cases could be worth a great deal of money. The beneficiary would probably use the proceeds in the form of a lump sum to pay off expensive borrowings, but most people would want to keep that tax-free fund as long as they could, if only to finance their lifestyle.
Keeping the fund intact
There is actually a good reason why one might want to keep the fund intact and possibly not even draw on it, and that is that it could go down to the next generation, as we will see.
The position is near fiscal perfection if the pension scheme member dies before reaching the rather arbitrarily selected age of 75. But if you are inconsiderate enough to die on your 75th birthday or later, the position is still very good. It is worth remembering that most people make it to their 75th birthday and beyond.
If you inherit a pension fund from someone aged 75 or over, the withdrawals – drawdown or annuity – will generally be treated as if they are your taxable pension income. But there will still be no IHT. It is as if you had received a fund that accumulates tax free but is taxable if and when you draw on it.
I have used the weasel word “generally” to describe the tax position because, for the tax year 2015/16, you would pay 45 per cent tax if you drew a lump sum. For the following year the plan is that lump sums would be taxed in the same way as income. You would not take a lump sum in these circumstances in 2015/16, would you? Possibly just a largish income.
If you are the person who has been nominated to receive someone’s death benefits, the benefactor’s age at the time of death is the determinant of your tax status on the benefits you draw.
It is much the same with the next iteration of death and the passing down of the pension fund.
Supposing you, the original pension member’s nominee, die before you reach 75. Your successor, who inherits this lump of money, will not pay tax on the withdrawals – and it will not be part of your taxable estate. If you live to 75 or more, your successor will be landed with paying income tax on the withdrawals but will still enjoy an attractive situation with a fund that has escaped IHT.
And so it can go on down the generations. At least in theory – and as long as it lasts.
So how long might it last? What should one say to clients about possible changes?
The first thing is that tax law can and does change. How it will change in the future is anyone’s guess.
A source of some comfort, as Fidelity FundsNetwork’s Paul Kennedy points out, is that successive governments have made lots of tax changes and almost none have been retroactive.
But you cannot be sure the benevolent tax regime for inherited pension pots will go on indefinitely. Some government at some point might just say an extra income tax rate or IHT or some other invention should apply to these millions passing down the generations free of tax for no obvious reason.
So my suggestion is that planning to cascade pension wealth down the generations is well worth recommending. What is there to lose? But do not suggest clients put all their IHT and estate planning into the pensions basket.
It pays to diversify with tax planning, as with investing. Do not give up on the life policies gifted in trust, the business assets relief investments, the gift and loan plans or the discounted gift plans. They remain powerful weapons in the planning armoury.
Danby Bloch is editorial director of Taxbriefs Financial Publishing