It still surprises me somewhat that the long-term opportunities of the death benefit regime accompanying the pension freedoms are not fully appreciated by all. Before freedoms were introduced, a pension scheme paid out the death benefits at the trustees’ discretion, informed by the nomination/expression of wish completed by the pension holder. The cheque would be drawn, paid out and owned by whoever received it – be it a spouse, trust, child or other beneficiary. Indeed, one of the concerns on death benefit planning was deferring inheritance tax on first death to the death of a spouse in many cases.
The new rules are very different. Although the expression of wish form is still needed, the money can stay in a pension scheme and, with flexi-access drawdown, the beneficiary can take as much or as little income as they need from the pot, with future successors able to designate any residual benefits on the second death to do the same.
If the pension holder was under age 75 when they died, then the income can be paid tax-free to the beneficiary as long as the plan was designated for drawdown within two years of death. If the pension holder was over 75 at death, then the income will be taxed at the beneficiary’s marginal rate of tax.
So, if the beneficiary needs the income they can take it. If income is not needed, the fund can be left where it continues to have the tax advantages of a pension scheme and the beneficiary can nominate their own “successor” beneficiary. Let’s look at some examples.
Dave and Dawn
Dave Davison dies age 76 and has nominated his wife and his children as beneficiaries to receive income death benefits from his drawdown fund. But does it go to his wife Dawn (designated) or is it passed down to the two children, David and Davina?
It might be that Dawn needs the money and will have to draw on the fund. Tax will be paid at Dawn’s marginal rate. Dawn is currently a higher-rate taxpayer in her role as an accountant.
Dave might be unsure whether Dawn will need the money but it is designated to her just in case. A key advice point might be whether Dawn will continue in her professional role.
“The beneficiary can take as much or as little income as they need from the pot, with future successors able to designate any residual benefits on the second death to do the same”
In the end, she takes little or no money from the fund and nominates David and Davina to be her successors. If she dies before age 75, then these benefits will be tax-free in their hands.
Alternatively, the aim might be to pass the money on immediately to the two children directly from Dave. Again, the tax paid will depend on each child’s marginal rate of tax as Dave was over 75 when he died. It could well be the two children could draw out up to their personal allowance free of tax.
If the children are minors, they will need someone to take parental responsibility and control of the fund. This might not be an issue, particularly if Dawn were available to take this role. To cover the event of her early death, Dawn should make a provision in her will for the appointment of a guardian.
The children will be able to make their own decisions in respect of the fund on reaching 18 and any careful tax planning could all be undone if they decided to take the whole lot and spend it.
If at the start of the process this is a concern, then going down the route of putting benefits into a spousal bypass trust might assist. There might be additional tax and expenses to pay but there will be control by the trustees.
With a large pension fund, the ability to pass it down the generations could continue well into the future, and even to David and Davina’s children.
The key to all this will be a detailed plan, perhaps involving:
- The potential universe of beneficiaries on death prior to age 75 and their need for income
- The fact the universe will look different for death after age 75 and now may include the marginal rate payable by the beneficiaries
- Spousal bypass trusts can give full control and might be a part of any wider solutions.
It is vital to keep the expression of wish form up to date and to revise any plan as circumstances change.
Mike Morrison is head of platform technical at AJ Bell