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Drawdown rawbacks

There could be a nasty shock in store for people taking income drawdown.

Many IFAs recommend drawdown for clients at retirement as a flexible method of providing an income and keeping control of the capital. But it is important to be aware of one potential problem that could happen without a little foresight.

The amount of income taken under a drawdown arrangement is limited both in the minimum that can be taken and the maximum, with the limits set by the Government Actuary. Under current rules, an annuity must be purchased with the remaining fund at 75.

By opting for the minimum income, the value of the pension fund will be used up less quickly than if the maximum income is taken. This means there will be a greater pot to buy an annuity at 75 or to pass to beneficiaries on death before this age.

When a person who has implemented drawdown dies before reaching 75, the remaining fund passes to the beneficiaries, less a tax charge of 35 per cent. However, there is also a potential inheritance tax charge on the remaining fund.

When a person dies, it is the duty of his or her legal personal representative to administer and distribute the personal estate. Before they can do this, they have to complete Inland Revenue forms, which include questions about pension arrangements. This is how the Capital Taxes Office finds out about these arrangements and cases where inheritance tax may be due.

Last year, the ABI and the CTO finally agreed guidelines on the IHT position on personal pension income withdrawal. One part says a claim for IHTwill not be made where the pension arrangement is a genuine pension arrangement, made and operated to provide retirement benefits.

Outside this, a claim could arise if there is evidence that decisions were made or action taken deliberately to increase somebody else&#39s estate rather than to make provision for the individual&#39s retirement.

Most typically, this would be where a member was in ill health when the decision was made and acted on. “Ill health” in this context means terminally ill or in such ill health as to be uninsurable.

As a rule of thumb, if somebody made a decision or took action and lived for two years, then he is deemed to have been in good health at the relevant time. But this is not the case if, when the decision or action was taken, he knew he was in serious ill health and got lucky and lived for two years.

Given these circumstances, the beneficiaries of anybody who sets up an income drawdown arrangement based on the minimum income level, in the knowledge that they may die within two years, could be liable to an IHT charge. By taking the minimum income, the amount payable to the beneficiaries would be maximised and could be seen as deliberately increasing the beneficiaries&#39 estate.

Charles Mullins, the Edinburgh-based partner of independent financial adviser The Pensions Partnership, finds the whole thing farcical. “If an individual takes the minimum income option when he knows he is terminally ill, he could be seen to be avoiding tax,” he says. “Also, if the income is varied between the maximum and minimum limits, the Inland Revenue sees this as a means of avoiding tax.”

Scottish Equitable pensions development director Stewart Ritchie points out these conclusions came after “years and years” of discussions and believes they are logical extensions of other IHT rules.

He says: “The way it has ended up is to project into the pension drawdown arena the principles that the CTO has been using for death taxes for donkey&#39s years,” he says, adding he has no particular view if they are fair or unfair.

But it appears the chances of the beneficiariesof an individual being charged with IHT in these circumstances are fairly unlikely. ABI pensions manager Bridget Moss says: “The good news is that, although these rules are in place, there are likely to be very few cases where there will be problems with IHT. It is only likely to occur in restricted circumstances where it is benefiting the spouse on the death of the policyholder.”

Despite the problems that could occur if the CTO feels there is an IHT case to answer, there are steps that can be taken to make sure there is no tax liability. Mullins says: “If a client is terminally ill and wants to set up income drawdown – because this is the best way of passing the estate to beneficiaries – we recommend that the maximum income is drawn.”

Ritchie says: “Anybody who has got an inheritance tax problem should address the issue while they are in good health.”

If an income drawdown scheme is set up, it is possible that checks will be made by the CTO to make sure there are no underlying reasons for setting up the arrangement. According to Mullins, the Revenue made checks once his client had died.

“The arrangement was investigated,” he says. “But, because the client was taking maximum income, there were no problems.”

Before setting up an income drawdown scheme, customers and their IFAs should make sure they have looked at all the alternatives to provide an income. “If the only alternative to income drawdown is to buy an annuity, the income drawdown route could be the lesser of two evils as far as the estate is concerned,” says Ritchie.

But Ritchie adds that, if anybody is going ahead with income drawdown, they should make sure all the reasons for doing so are well documented. “It is essential that people put in writing the reasons they are doing it,” he says.

Mullins has an alter-native way of using a pension fund to provide an income as well as preserving the remaining value of the fund. “An alternative is to use phased retirement, with only a small proportion of the fund in income drawdown” he says. “This will have the effect of protecting the assets in the tax-free proportion of the fund.”

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