Inheritance tax and Pensions

inheritance tax and pensionsThe changes to inheritance tax and pensions in 2014 have brought pensions back to the main stage when it comes to estate planning. It is now possible to leave a crystallised pension (a pension where drawdown has commenced) as an inheritance completely tax-free – as long as the deceased is under the age of 75. Previously a tax charge of 55% applied.

In the 17/18 tax year this will allow you to leave up to £1 million as an inheritance with no charge to tax. As you can hold a wide variety of assets within a pension, they are forming the cornerstone to many portfolios for high-income clients.

An exception to the rule

The exception to this is final salary scheme pensions: they cannot be left as an inheritance. This has caused some clients to review their pension structure.

There are several advantages to being in a final salary scheme pension: you have no investment or market risk, the income you have is guaranteed for life and it’s index linked. However, what happens to that income when you die?

What happens in final salary schemes

Normally, the surviving spouse continues to receive an income but usually 50% less than the previous benefit. When they die the pension ceases and its value expires leaving no pension inheritance.

For clients with over £1 million in their pension, this may seem unreasonable. After all, if the pension was in a personal scheme the full value could be left as a pension inheritance.

Due to this, the government expect 20% of current final salary scheme holders to opt out of their schemes and move to a more inheritance-friendly scheme. This could allow their families to benefit from any unused pension after they die.

When considering leaving a pension to beneficiaries as part of an inheritance, you will be asked to disclose if you would like it paid as an income or lump sum. We have found that many clients initially opt for the lump sum until we talk through the options. So let’s weigh up those options now.

Lump Sum

As the name suggests this allows the value of the pension to be left to beneficiaries as a tax free lump sum – if you are under 75 at the time of death. If you are over 75, the pension will be taxed as income at the highest marginal rate of the beneficiary. Many beneficiaries will pay the maximum rate of 45% due to the typical size of pension funds.

To many people, the ‘lump sum’ may seem like the obvious choice. Maybe they are pre-conditioned to the words ‘lump sum’ – the term being associated with the tax-free lump sum that is available upon retirement? However this option may not be as attractive as it seems.

In a pension, the funds are held within a very tax efficient wrapper. They would not form part of the beneficiary’s estate. There is no tax to pay on investment growth, and as inherited pension value they do not count towards the lifetime allowance of the beneficiary. As soon as they are removed from this wrapper all of these benefits are lost.

If you are 75 or older when you die, the lump sum itself can push the beneficiary’s tax rate into the 45% bracket resulting in a large charge to tax on the funds received.

Income

The word income seems to create the thought that access to the funds would be limited. That the beneficiary would only be entitled to the income the investments produce. This is a misconception. The definition of income in pension terms simply means: free to make withdrawals of any amount on demand.

The advantage here is that the beneficiary still holds the funds within the tax efficient pension wrapper. They can draw down funds from the pension, tax-free, whenever they wish. Any investment growth inside the pension is tax-free and the full value remains outside the beneficiary’s estate for inheritance tax purposes.

Pensions inherited past age 75 can remain inside the pension and will only be taxed when withdrawals are made. This allows the beneficiary to control the release of funds from the pension in accordance with their other earnings in that year and avoid being taxed at 45%.

When you consider that selecting the income option will provide you with all of the benefits of the lump sum, but also provide much more flexibility to plan the tax-efficient withdrawal of the funds, the choice is clear!

Find out more?

For more information on inheritance tax planning regarding your pension feel free to contact a member of our investment team. We operate an open information policy and will happy to discuss your case over the phone with no obligation.

Call us on 0844 338 6622 or email on info@cwpwealth.co.uk

Capital Wealth Partners Limited is a company registered in England and Wales and are authorised and regulated by the Financial Conduct Authority.