The ideal inheritance plan allows you to pass an asset down to the next generation tax-free on death but be able to access it for your own use beforehand if needed. Defined contribution pensions enable you to do just that.
The default strategy of many advisers now is to recommend their older clients keep their pension funds intact as long as they possibly can, only drawing on them if needed for long-term care or other later-life requirements. The pension fund can then be passed down free of IHT to the next generation, and perhaps even beyond.
It is a win-win situation. Retain the pension for as long as possible and die with it: heads, your family wins. Hold onto the pension as long as you can and spend it on having the best possible end of life long-term care: tails, you win as well. OK, death and dementia do not sound like winning but you see what I am saying. But is it really that straightforward?
Keeping things IHT-free
The elements of pension freedoms that introduced the current position were the lifting of the restrictions on taking benefits before age 75 and the new tax rules on death benefits. An individual does not have to take their pension benefits before reaching the age of 75. They can just leave them undrawn, or partly drawn. And there are no longer any restrictions related to reaching age 75 on the pension commencement lump sum and most other lump sum death benefits.
True, if there are uncrystallised funds at age 75, there is a benefit crystallisation event (BCE5) to test the level of benefits against the lifetime allowance. But that is pretty much it.
Death benefits – lump sum or income – post-age 75 are subject to income tax in the hands of the person who receives them and taxed accordingly. If you are the beneficiary of someone who has died before age 75, you have won a fiscal lottery and your lump sum will be free of income tax. This fiscal “luck-of-the-draw” system will bizarrely continue for death benefits cascading down later generations. At least for now.
Lump sum death benefits are virtually always free of IHT. There is something of a question mark over contributions to pensions or transfers to defined benefit schemes made shortly before the member’s death, especially if they were in poor health at the time. But otherwise the position is pretty safely free of IHT.
So for the minority of people with enough other non-pension capital and income, the natural strategy would be to leave the pension to pass IHT-free to their families, only drawing on it as a last resort.
As mentioned, though, this last resort could arise if they are unfortunate enough to need some expensive long-term care. This could easily end up costing as much as £50,000 a year; possibly much more depending on the degree of luxury they want and where they live.
At that point, the basic strategy of holding onto the pension for as long as possible might not turn out to be the best thing to do in particular circumstances.
Lots of factors could come into play here and affect the choice between selling a home or drawing on a pension. The existing property might be needed to house a surviving partner or other dependant, or a downturn in the property market could make it hard to sell. It could be that it is better to rent the home and get a yield. There is also the issue of how large the IHT nil-rate band might be at the time, compared with the client’s potential estate at death.
One question is whether to draw the PCLS reasonably early on – say, while the client is in their late-60s or early-70s. Of course, it all depends on circumstances.
The advantage is that the undrawn PCLS will boost the value of the client’s IHT-free fund. But against that, an asset that was once income tax free will almost certainly be taxable in the hands of the person who inherits it. The strategy would save IHT only to end up generating an income tax liability – although possibly at a lower rate depending on the recipient’s circumstances.
So it might be better for some scheme members to draw their PCLSs early on. They might decide to use it for making a lifetime cash gift, setting up a trust or just for buying an investment that qualifies for business property relief. After all, a BPR investment has much the same win-win advantages as a pension, it is just that the underlying investments mostly have to be rather more risky and restricted. Hang on to your pensions.
Danby Bloch is chairman at Helm Godfrey