These changes affect uncrystallised pensions, drawdown pensions and annuities.
Under the new rules the key factor is the age at which a member dies.
OPTIONS AND TAXATION
Member’s age at date of death
&Options and taxation at date of death
Pre age 75
- Tax free lump sum
- Tax free income via drawdown
- Beneficiary’s annuity free of tax
Age 75 or over
- Drawdown taxed at beneficiary’s marginal rate
- Lump sum payment taxed at 45% (expected to be at beneficiary’s marginal rate from 2016/2017).
- Beneficiary’s annuity taxed at marginal rate.
DEATH BENEFITS WHERE A MEMBER DIES PRE AGE 75
A member will be able to nominate any beneficiary and payments to that individual will be made free of tax, whether it is:
- Taken as a lump sum
- Accessed through drawdown or
- Paid to a dependant or not.
The nominated person can take the benefits as they choose either as a lump sum or a regular or flexible income. All withdrawals would be free of tax. Beneficiary’s annuities will also be free of tax where the annuitant or member dies under age 75.
DEATH BENEFITS WHERE A MEMBER DIES AGED 75 AND OVER
As above, the member will be able to nominate any beneficiary to receive the death benefit. Payments to the chosen beneficiary will be subject to income tax at the beneficiary’s marginal rate where the funds are taken as income. There are no restrictions on the level of withdrawals that can be taken i.e. the nominated beneficiary can take the whole fund at once. There is also an alternative option which the Government says it intends to be temporary (until 2016/2017). This allows the beneficiary to receive the benefits as a one-off lump sum payment subject to a tax charge of 45%.
This option is to allow for products that do not yet have the flexi-access drawdown option available. Where flexi-access drawdown is available and the recipient’s marginal income tax rate is below 45%, taking the whole lump sum via flexi-access drawdown would be the preferable option.
Note though that where a death benefits lump sum takes the recipient’s total income over £100,000, the marginal rate will be 60% on at least some of the benefits as this will result in the loss of some or all of their personal allowance.
Where a member or annuitant dies aged 75 or over ‘dependants’ annuity payments will continue to be paid at the beneficiary’s marginal rate of income tax. The new rules will allow annuities to be set up permitting any beneficiary to receive the income.
PASSING MONEY DOWN THE GENERATIONS VIA DRAWDOWN
The new rules also allow the nominated beneficiary to pass on any unused drawdown funds on their death to their own nominated beneficiary, known as a successor. The same tax treatment will apply but the relevant age will be the age of death of the beneficiary rather than the original member. If the original beneficiary dies below age 75 the successor can receive a tax free lump sum or continue with tax free drawdown. If the beneficiary dies age 75 or over then any benefits can either be taken by the successor as taxable drawdown income or a lump sum taxed at 45%.
This gives the potential to pass pension funds down through the generations without ever falling into anyone’s estate for inheritance tax (IHT) purposes. In addition, the funds can remain in a tax advantaged environment and have the potential to provide a tax free income where the member or
beneficiary dies before reaching age 75. Technically there is no end to this planning, a successor could also pass their remaining funds down to a further successor and so on. Of course, most members or their beneficiaries will need the funds to provide an income in their lifetimes but this does give members who have other funds a very useful planning option.
Simon dies at age 65 with a £200,000 fund. He has nominated his wife; Lindsey aged 60 to receive the funds as she will need them to supplement her own relatively modest income. She decides to take dependant’s drawdown so the funds can remain in a tax efficient environment, remain outside
of her estate for IHT and she can benefit from tax free income. Lindsey takes a tax free income of £12,000. A year until she dies at age 74. The fund is then worth around £160,000*. Lindsey nominates her daughter Andrea to be her successor. Andrea is aged 48 and a higher rate taxpayer. Andrea also decides to keep the funds in drawdown. She plans to take a tax free income later when she plans to reduce her working hours. If there are any funds left on her death she can pass them on again to her own nominated successor. If Lindsey had survived to age 75 she could have reviewed and potentially updated her nomination. As the remaining funds would then be subject to income tax she could have instead nominated her grandchildren. Her grandchildren are aged 18 and 20. The funds could have remained in drawdown and then used to help fund them through university. The grandchildren could draw funds using their personal allowances each year and if so, minimise any tax payable.
*Figures are solely to illustrate the planning point and do not represent indications of actual growth
The new rules will make bypass trusts less attractive and in many cases unnecessary. One of the main uses of the trust currently is to keep the pension funds outside of the spouse’s estate whilst allowing them to maintain access to the funds at the trustees’ discretion. Any unused funds can then be passed down the generations with no IHT on second death. As explained above, this can now be achieved by keeping the funds in pension drawdown. The pension option has the added benefits of the funds remaining in a tax advantaged environment for growth and income.
It also avoids any potential IHT periodic and exit charges as well as the administrative complexities of having to use a trust. Of course there will still be situations where a bypass trust may be suitable, for example, where individuals have complex family situations. Here they may desire a greater degree of control over how assets are distributed. However, the additional control will now usually come with a tax cost rather than previously where there was often a clear tax benefit. In addition, to achieve the required control in complex situations, this may need to involve bespoke trusts and the appointment of professional trustees which will further increase the costs. It may be worth reviewing any bypass trusts that have been set up to ensure they are still required in light of the new rules. Where a bypass trust is no longer suitable the member can simply change the nomination in favour of their new chosen beneficiaries and the trustees can distribute the nominal trust fund, normally £10 to one of the beneficiaries.
DEATHS BEFORE APRIL 2015
The new rules will apply where the first payment is made on or after 6 April 2015 regardless of the date of death. However, the two year rule still applies to payments of benefits (see below).
TWO YEAR RULE
The two year rule remains and to ensure the tax advantages, payments to beneficiaries need to be made within two years of the member’s death. The same rule will apply when the nominated beneficiary dies and passes funds onto a successor. The rule also applies where the beneficiaries wants to continue in drawdown. However, they only need to make the designation into drawdown, there is no requirement to take any income.
LIFETIME ALLOWANCE (LTA)
The lifetime allowance still applies so if the benefits haven’t already been tested against the LTA then they will be and any excess will subject to the LTA charge in the normal way. New benefit crystallisation events ensure that any uncrystallised funds are tested when used to provide death benefits for the nominated beneficiary.
Where the member has not made a nomination and has left any dependants, the scheme can only set up drawdown for someone who is a dependant. Where the member has not made a nomination and has not left any dependants, the scheme can nominate any individual to receive drawdown.
Schemes retain any existing discretionary powers in respect of lump sum payments. Payments to individuals will be taxed in the same way as to those nominated. It will now be even more important to ensure existing nominations are up to date so that they can make the most of the opportunities the new rules provide. It will also be important to review nominations for any individuals still invested at age 75. The change in the taxation of death benefits at that point may mean an alternative beneficiary is more appropriate.
Partner Alexander Beard Wealth LLP - Leeds branch