19 Jan Keeping it in the Family
There has been much excitement in the pension world since it was announced the Government would lift restrictions on how you can access pension savings, at the extreme end allowing you to take the entire pot in one lump sum.
The Chancellor, however, left the biggest surprise until last when he firmly positioned pensions as the estate planning vehicle of choice for those with larger pension funds. Here are our top tips to help enable you to pass on as much of your accumulated pension wealth as possible to your nearest and dearest.
Wealth transfer vehicle
Retaining pension wealth within the pension fund and passing it down to future generations can be an extremely tax efficient estate planning solution. It combines Inheritance Tax (IHT) free payments with tax efficient investment returns and, potentially for some beneficiaries, tax free withdrawals.
The new rules will allow Money Purchase (as opposed to Final Salary) scheme members to nominate any individual to inherit the remaining pension fund as what is known as a “nominee’s flexi-access drawdown account”. This can be anyone at any age and is not restricted to your ‘dependants’ as it used to be. Adult children can now benefit and don’t have to wait until 55 to access it.
If you die after age 75, any withdrawals will be taxed at the beneficiary’s marginal rate. But if death occurs before age 75, the nominated beneficiary has a pot of money they can access at any time completely tax free. In either case, the funds are outside your estate for IHT while they remain within the drawdown account and will continue to enjoy tax free growth.
This is also the case for those funds already in pension drawdown as they will benefit from the same death benefits options and tax charges.
Adviser Comment: I foresee this as a u-turn in strategy for those of you whose primary concern is maximising what can be passed on. The previous wisdom of stripping out funds and gifting the surplus income to minimise the impact of the old 55% tax charge has given way to retaining funds within the pension as a more tax efficient solution.
The ability to pass on pension wealth doesn’t stop there. The nominated beneficiary can nominate their own successor who will take over the drawdown account following their death – unlike the current rules where lump sum death benefits are the only option for non-dependants.
This will allow accumulated pension wealth to cascade down the generations, whilst continuing to enjoy more of the tax freedoms that the pension wrapper will provide.
But this relies on the existing pension arrangement being able to offer the nominees’ and successors’ drawdown accounts. Some schemes may only be geared up to offer a lump sum death benefit which would lose the protection of the pension wrapper for IHT and any income tax payable would be shoe-horned into a single tax year, pushing up the beneficiaries marginal rate for that year and therefore incurring more tax.
Adviser Comment: It is essential to review your pensions before the end of the tax year as clients need to make sure their existing pension is fit for purpose in the new world.
Tax Free or Taxable?
Each time a pension fund is inherited by a nominee or successor, the tax rate will be reset by the age at death of the last drawdown account holder.
For example Fred, a widower, dies age 82 and nominates his son James to receive his flexi-access drawdown account. As Fred dies after age 75, James is taxed at his marginal rate on any income withdrawals. James dies age 70 and leaves the remaining fund to his daughter Helen. Helen can take withdrawals from her successor’s drawdown account tax free as John died before 75.
Adviser Comment: For clients younger than 75, it’s worth considering skipping a generation with at least some of the pot to ensure a tax-free inheritance for your children or even grandchildren. At the very least, everyone should review their pension death benefit nominations as soon as possible. It’s also worth discussing whether your existing scheme will even allow your preferred solution.
Two by Two
Death benefits will only be tax free for deaths before age 75 if they distribute or the nominee flexi-access account is set up within two years of death.
Failure to designate the funds for drawdown within this two year window will see benefits taxable as income. Where funds are taxed as income they do not count towards the lifetime pension allowance (LTA). This could mean those individuals with funds in excess of the LTA may want to weigh up the merits of delaying setting up a nominee flexi-access account, to see if the tax charge for exceeding the LTA is greater than the potential income tax charge payable by the nominated beneficiary.
Adviser Comment: This is a key reason to having an adviser associated to your pension fund. We provide the bridge between the generations to ensure funds are distributed in the most tax efficient manner.
Remember – Money Purchase or Final Salary
If you have a final salary, (otherwise known as Defined Benefit) fund, then these new reforms will not apply and you’ll be unable to take advantage of the new pension flexibility. It might be possible to transfer your fund to a Money Purchase (or Defined Contribution) fund, but you should talk to a professional adviser to make sure this is the right choice for you.
Bypass Trust – why you still might want one
It’s worth remembering that each time pension fund is inherited it’s the new owner that has control over the eventual destination of those funds. Not only can they nominate who benefits on their death but, under the new flexibility, they could withdraw the whole fund themselves leaving nothing left to pass on.
This may be an issue where there are children from previous marriages or concerns about a beneficiary’s ability to manage their own financial affairs, either through a lack of capacity or their own reckless spending habits.
Where control is an issue, it is possible to pay a lump sum death benefit to a Trust which will put the control into the hands of the member’s chosen trustees. The trustees can determine when and how much to distribute to beneficiaries.
Adviser Comment: Trusts are the ultimate intergeneration wealth preservation tool and while the new pension rules provide fantastic flexibility compared to what was available previously, those who want ultimate control should speak with us about pensions and trusts.
Should You Take Your Tax-Free Cash?
The changes will see many behavioural changes on how benefits are taken. Currently, some pension savers have been delaying taking their tax free cash until 75 to escape the current 55% tax charge on crystallised funds. But what now with the 55% tax charge disappearing in April 2015 and equal treatment between uncrystallised and crystallised funds?
What do crystals have to do with anything? Well, crystallised and uncrystallised are the terms used by HMRC to denote pension funds where distribution has commenced (crystallised) or those which have not yet been distributed (uncrystallised).
There’s no longer any reason to delay taking tax free cash if it can be gifted and outside the estate after seven years. But if the tax free cash remains in the estate and suffers IHT at 40%, it may be better to leave the cash within the pension fund if the beneficiary is able to draw on it at basic rate or less.
Adviser Comment: For those with significant assets, I now see the pension as the savings vehicle of choice, rather than the one that is accessed as funds of last resort. This is a sea change and will require regular reviews with your adviser to ensure your non pension assets are managed to complement this transformation.
Steve Petrie, Independent Financial Advisor, Wren Sterling