The pensions reforms introduced in April 2015 are very welcome and provide greater flexibility with regard to death benefits. There are, however, now more complexities and options than ever before so it is essential to review your arrangements in light of the changes.
There are a raft of different pension arrangements: this article comments on the most common type held by our clients – defined contributions pensions, including Self-Invested Personal Pensions, modern personal pensions and money purchase occupational schemes.
The majority of pension arrangements are trust-based, so following the pension holder’s death, death benefits are paid at the scheme trustees’ discretion and are not liable to inheritance tax (IHT). However, some pensions, particularly older policies, can be different, so you should always take specialist advice about your particular scheme’s rules.
New freedoms for death benefits
Death benefits can still, as previously, be paid in lump sums to anyone classed as a “dependant” under the scheme’s rules, which usually includes spouses and children under 23.
The new flexibilities also allow pension holders to nominate any individual (older children, other relations or even non-relations such as friends) to inherit their pension pot and to draw on these funds as and when required. Nominees can, in turn, nominate who should benefit from any funds remaining in their allocated pension pot following their own death.
In simple terms, under the new rules, if the pension holder dies before the age of 75 the funds can be extracted from the pension tax free. Alternatively, monies can be retained within the pension for nominated individuals, who can withdraw their allocated funds tax free at any time in the future.
For deaths at or over 75 years of age, during this tax year all lump sum extractions will suffer a 45 per cent tax charge. From next year, the 45 per cent rate applies if funds are paid directly from the pension into a family trust; any other lump sum payments (ie, to individuals) will be taxed at the income tax marginal rate of the recipient. If the funds are retained within the pension but allocated for nominated individuals, they will be taxed at the recipient’s marginal rate upon later extraction.
The above assumes any lump sum payments/allocations are made within two years of death and that the total pension fund is within the member’s Lifetime Allowance – which reduces to £1 million in April 2016.
Your overall estate planning strategy should be reviewed in light of these changes. It will often make more sense, from an inheritance tax perspective, to retain funds within your pension and spend funds in your personal estate instead.
Prior to the new rules being introduced, it was also common for lump sum benefits to be paid into a family trust (sometimes referred to as a “spousal by-pass trust”) which could benefit the surviving spouse but wouldn’t form part of their taxable estate on their own death, thus potentially saving 40 per cent IHT on the value.
It may still be appropriate for death benefits to be paid to a trust, especially while under 75, but we recommend this planning is reviewed in light of the changes and individual family circumstances. Tax is not the only consideration – wealth protection and who has control of the funds are also key issues.
It is sensible to preserve the maximum amount of flexibility permitted under the new laws and the individual scheme’s rules, and (if possible) for a decision about how to extract pension monies to be taken after the pension holder’s death. At this stage the family’s circumstances, asset values and applicable legislation will all be clearer. In the meantime, we recommend you leave clear guidance to your scheme trustees setting out your wishes about the intended beneficiaries of your pension and anyone you would like the trustees to consult when deciding on the allocation of funds. A well drafted nomination form can both help to save tax for the family and prevent disputes arising in the future. It should tie in with your Will and provide for “default” beneficiaries whom you would wish to benefit if your intended beneficiaries die before you.
In order to benefit from the new pension freedoms, some positive action to nominate your chosen beneficiaries is likely to be required. It is recommended that:
- Any existing nominations/letters of wishes are reviewed.
- Scheme rules are considered and updates made to nominations/letters of wishes as necessary.
- Any nominated family trusts are reviewed.
- Maximum flexibility is retained by preparing a bespoke letter of guidance to the scheme trustees.
With the amounts at stake, obtaining sound legal and financial advice in this area is essential.