Pension reforms thwart death tax spectre

A staggering £3.4 billion of inheritance tax (IHT) was paid in the 2013/14 tax year, up 8.6 per cent on the previous year. That figure was a reflection largely of rising property values over a period when the nil-rate band (the amount you can leave before IHT kicks in) has remained frozen at £325,000.

But exemptions, allowances and planning strategies provide various ways to reduce your liability - and changes to pension rules mean that in future there will be more opportunities to avoid leaving your loved ones a chunky tax bill.

In particular, the new pension death benefit rules, which will see the amount of tax cut significantly in many instances, have the potential to overhaul IHT planning.

'Pensions will play a far more important role in how we pass our wealth on through the generations,' says Patrick Connolly, certified financial planner at Chase de Vere. 'In some instances it will be possible to pass pension wealth on completely free of tax.'

CURRENT RULES

As pension assets sit outside your estate for IHT purposes, it's always been possible to pass any remaining pension pot on without triggering an IHT liability.

However, historically most people have simply used their pension fund to buy an annuity, and these 'die' with the annuitant (or, in the case of joint annuities, on the death of their surviving spouse).

Even if you didn't buy an annuity, tax rates well in excess of the 40 per cent charged for IHT meant passing on your pension was never a particularly attractive option.

Patrick Murphy, chartered financial planner at Zen Wealth, explains: 'Under the current rules, pension funds can only be passed on tax-free if you die before you reach age 75 and you haven't started drawing benefits.

'Live beyond 75, or go into drawdown before this point, and any remaining fund could be taxed at up to 55 per cent.'

DEATH BENEFIT RULES

But such hefty tax rates will be a thing of the past from this April, when the new, simpler and more generous pension death benefit rules come into force (see table above, click to enlarge).

Under the new rules, if you die before age 75 anything remaining in your pension pot can be taken completely tax free, either as a lump sum or as a series of withdrawals.

As well as applying to any remaining pension pot, this tax-free status also applies to a surviving spouse's income payments and to any payments that are left under an annuity guarantee.

If you die after age 75, tax becomes payable. However, while any remaining pot would have been hit with a 55 per cent tax charge under the old rules, after a transitional rate of 45 per cent in 2015/16 the recipient will only pay income tax at their marginal rate on anything they withdraw.

Further, as they'll be able to decide when they make withdrawals, there will be room to adjust that income stream to control the amount of tax paid.

MORE RELAXED ON DEPENDANTS

The new rules are also much more relaxed about who can inherit your pension. Current rules state that it can be left to a spouse, which, depending on the scheme rules, could extend to an unmarried partner or a child under the age of 23.

But, from April, you'll have much more freedom around whom you can nominate, allowing you to leave your pension to a spouse or partner but also, potentially, an adult child or even a grandchild.

And it will be possible to pass a pension pot down from generation to generation, with the tax status potentially changing each time, depending on the pension holder's age at death. As an example, if a grandfather dies at 71, his widow would have tax-free access to the money.

If she died at 81, leaving the remaining pension pot to her adult son, any income he took from it would be taxed at his marginal rate. But, if he subsequently died at age 60, his child could inherit it tax free.

Although this flexibility is a major plus when it comes to inheritance planning, Murphy advises some caution. He explains: 'The person who inherits the pension fund can withdraw it, in whole or in part, at any age and not just when they reach retirement. It's therefore very important to consider the implications of this for minor children or grandchildren.'

Even in the hands of a more mature recipient there can still be potential problems, with inherited pension pots potentially divided up in messy divorces, or lost altogether following bankruptcy or a spouse remarrying.

To avoid these possibilities, Julie Hutchison, family finance expert at Standard Life, says it may be worth considering a bypass trust. These are set up before death, enabling your pension pot to be paid into a discretionary trust when you die.

'You need to appoint trustees and write a letter that details how you would like to see the money passed on,' she explains. 'There are additional costs to consider, including the potential for further tax due to the way that trusts are taxed, but you do get the reassurance that your wishes will be followed and your pension will be passed on in the way you wanted.'

PUT YOUR PENSION LAST

These new rules, coupled with the fact that pension assets aren't liable to IHT, have the potential to transform how we view inheritance planning. 'If you can afford to leave the money in your pension, this could be worth considering,' explains John Chew, product and funds director at Legal & General.

'Unless you're able to spend the money, or pass it on tax efficiently, there's a risk that anything you take out of your pension will not only be subject to income tax but will also form part of your estate and potentially push up a future IHT liability.'

Keeping money tucked up in the IHT-free pension environment enables you to focus on trimming your estate. Although it will take seven years for a gift to leave your estate, Chew recommends taking advantage of the allowances and exemptions that are available (below).

'These can help to reduce the value of your estate, but do make sure you keep records, as your beneficiaries may need to be able to prove to the taxman that your gift was an exemption,' he explains.

It's also possible to use a trust to move money down the generations. This will give you greater control over who receives the money and when but, again, it will take seven years to leave your estate. Trusts can also be costly to run.

With less time on your side, you could consider some of the investments that qualify for business property relief. These fall outside your estate for IHT purposes after just two years of ownership, and include Enterprise Investment Schemes and qualifying shares listed on the Alternative Investment Market.

But this strategy is not without its risks, as such investments can be quite volatile and you could lose more than the IHT you set out to save. A financial adviser should be able to help.

Paying more into your pension is another valuable IHT planning strategy. For example, say you paid £8,000 into a pension, which would be topped up to £10,000 with tax relief.

It could go to your kids tax free if you died before age 75, or subject to income tax at their marginal rate if you were older when you died. In comparison, the original £8,000 could be reduced to as little as £4,800 if it remained in your estate and was subject to IHT.

This option could become very attractive, according to Murphy. 'The new rules make pensions a valuable way to pass wealth to the next generation in a tax-efficient manner,' he explains.

IHT ALLOWANCES

A variety of exemptions and allowances are available to help you reduce a future IHT liability. These are:

  • Annual gift allowance of up to £3,000 - any unused allowance can be carried forward but only for one year.
  • As many gifts of up to £250 per person each year as you like, providing they have not received any other gift.
  • A wedding or civil partnership gift - how much you can give will depend on your relationship to the bride and groom, from £5,000 for a parent through to £1,000 for anyone else.
  • Regular gifts out of taxed income - these could include birthday presents, life assurance premiums or regular payments into a savings account. Importantly, you as donor must be able to maintain your normal lifestyle.
  • Gifts to help with another person's living costs - these include maintenance to a former spouse or civil partner; a child under 18 or in full-time education; or a relative who is dependent due to old age, illness or disability.
  • Gifts to charities, museums, universities and community amateur sports clubs. In addition, if you give more than 10 per cent of your estate to charity, your estate may qualify for IHT at 36 per cent instead of 40 per cent.
  • Gifts to recognised political parties.
  • Gifts to a spouse or civil partner, providing they live in the UK permanently.

More details about IHT allowances can be found on the government website.

Subscribe to Money Observer Magazine

Be the first to receive expert investment news and analysis of shares, funds, regions and strategies we expect to deliver top returns, plus free access to the digital issues on your desktop or via the Money Observer App.

Subscribe now

Add new comment