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Plan successor drawdown with confidence

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MONEY PURCHASE PENSIONS AND INHERITANCE TAX PLANNING

The Freedom & Choice reforms, in addition to making money purchase pensions more accessible, significantly improved the tax position and availability of death benefits. The combination of changes that were made transformed drawdown into a simple and effective inheritance tax (IHT) planning vehicle in certain circumstances.

Traditional IHT planning is usually centred on investment bonds, life policies, trust deeds, gifts between parties and often requires the involvement of solicitors. When it comes to tax planning, however, there is rarely a single solution to the problem of how to legitimately reduce your tax bill. Irrespective of how deeply ingrained a particular approach is for how long it has been the traditional practice, all that matters is how – whilst staying on the right side of the rules – a tax bill can be minimised. And often, the simplest approach for a particular individual will be the most appealing. So can a money purchase pension – specifically, a personal pension – represent a viable alternative to the formal world of traditional IHT planning?

The answer for most will be no; the primary purpose of a pension is to save for retirement and, in many cases, the fund will only be sufficient (or may eventually prove insufficient) to provide adequately for the member’s own needs. However, those who already have sufficient retirement provision and have spare income or capital might want to consider whether a personal pension can help them reduce their IHT bill.

Please note there are three main occasions when pension activity can result in an IHT charge. In outline they are contributions, transfers and irrevocable trusts for death benefits whilst the member is in serious ill-health. As these only apply when a member is aware of a terminal illness, they are not considered further in this article. For more details see our recent Techtalk article on this subject.

For those who can afford to use a personal pension for IHT planning, it stacks up quite nicely against a more traditional solution. Firstly, contributions to pensions can be paid without IHT consequences, provided the member is not in serious ill health at the time. This takes funds outside of the member’s IHT estate without any transfer of value. They must have earnings to justify personal contributions and available annual and lifetime allowances to avoid the tax charges associated with exceeding those allowances. Up to £40,000 can be removed from the estate each year using this approach although this will be lower for those who are restricted by the tapered annual allowance and/or money purchase annual allowance. Contributions already being paid to other schemes for actual retirement provision perhaps, including any paid by an employer and accrual within a defined benefits scheme, will also reduce the maximum that can be paid each year.

Once funds have been accumulated within a pension scheme, there is no IHT on any investment growth. Even though the funds are often held within a trust or equivalent structure there are no ongoing IHT charges and nor does the fund form part of any beneficiary’s estate. A personal trust/bond solution would either include the trust fund in the beneficiary’s estate (e.g. a bare trust) or raise periodic IHT charges (e.g. a discretionary trust) though these are often nil or very low amounts.

As a potential IHT planning vehicle, personal pensions would fall down if the distribution of funds to the beneficiary triggered a significant IHT charge. Paying death benefits to a beneficiary, however, does not ordinarily give rise to such a charge. For example, the payment of a lump sum death benefit to a beneficiary within the lifetime allowance should have no IHT consequences, other than the lump sum is then included within their IHT estate.

Even this drawback can be avoided by the beneficiary utilising drawdown rather than receive a lump sum death benefit. This option gives complete control over when funds are received and exactly how much is taken over the course of the tax year, allowing only necessary amounts to be withdrawn and the undrawn capital remaining outside their estate in an IHT-efficient environment.

And as per the lump sum, there is no IHT charge when funds are moved into beneficiary drawdown and no lifetime allowance charge if the member’s available lifetime allowance was not exceeded.


INCOME TAX

Outside of the potential lifetime allowance charge, the only tax charge to consider is an income tax charge on withdrawals from beneficiary drawdown or a lump sum death benefit. This also changed on 6th April 2015. If the member (or previous beneficiary) died before reaching age 75 death benefits are paid tax-free providing they are paid out or drawdown established within two years of death. For deaths on or after age 75 the beneficiary’s marginal rate of income tax applies. Once again though, that the amount and timing of payments from drawdown is at the beneficiary’s discretion gives plenty of scope for tax planning around the personal allowance and basic rate tax band helping to keep the tax bill to a minimum.


SUCCESSION

Another key benefit for personal pensions is that funds can be retained within the pension environment indefinitely and passed down through the generations by utilising beneficiary drawdown. This was not possible before 6th April 2015 as drawdown for death benefits could only be established for dependants. This generally meant only a spouse, minor child or some other ‘financial dependant’ could receive drawdown and so there wasn’t much scope for drawdown to continue for a long period of time: at some point the funds would have been paid out in the form of a lump sum as there were no dependants remaining.

This was changed on 6th April 2015 when the Freedom & Choice reforms came in so beneficiary drawdown can now be set up for anyone who was either dependant or was nominated as a beneficiary. A further change was the introduction of the new concept of a ‘successor’, who could be nominated by the current beneficiary to receive drawdown after their death. This meant that the death benefits could be passed from one beneficiary on to another – still within beneficiary drawdown – and remain outside of their estates but accessible at any time without IHT consequences.

The income tax treatment of beneficiaries is as explained above. A successor is treated in the same way as any other beneficiary but the tax they pay is determined by whether the previous beneficiary died below age 75 or not.


PROS AND CONS

The drawbacks of a personal pension being used in this way have to be considered. In addition to those already mentioned, the amount that can be paid in each year is limited by the annual allowance – as low as £10,000 if the tapered annual allowance applies or £4,000 for those who’ve triggered the money purchase annual allowance. This prevents large sums being accumulated at once, but those who have the full annual allowance available could potentially contribute £40,000 each year, which would accumulate into a significant sum quite quickly. Another drawback relates to an investment shortfall: should the existing retirement funds take a hit – perhaps because of a pension debit following divorce or poor fund performance – then any additional funds earmarked for IHT planning might have to be used to make up the shortfall. Finally, the non-binding nomination approach, which leaves the final decision over the recipient of death benefits to the scheme trustees, may not sit well with everyone.

The pros for money purchase pensions are simplicity, flexibility, low costs and the significant tax benefits covered above.


SUMMARY

For those with the luxury of being able to use a pension in this way, the IHT benefits are hard to match. Pension contributions should – other than when in serious ill-health – have no IHT consequences. The funds and, therefore, the investment growth within a pension are outside of the IHT estate. And, there is no IHT when lump sum death benefits are paid out or when drawdown is established for beneficiaries.

Couple this with freedom from income tax where the member / previous beneficiary died before reaching age 75 and the ability to use beneficiary drawdown to pass wealth down through the generations by nominating a beneficiary or successor to receive drawdown after the member or previous beneficiary’s death, and you’re left with a straightforward, tax-efficient solution to avoiding IHT on substantial amounts of capital for a potentially long period of time.

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This information is for UK financial adviser use only and should not be distributed to or relied upon by any other person.