Pensions & Inheritance Tax: How to pass on your pensions

Following changes to the treatment of money purchase pension death benefits in April 2015, a new opportunity for legacy planning opened up and pension drawdown has become an effective Inheritance Tax (IHT) and generational planning vehicle.

For those who have not taken advice or reviewed their pension, it is important to realise why these changes – which have been in place for six years now – can be so helpful.

Do pensions form part of an estate?

The majority (but not all) pensions have been considered outside of your estate for many years, and this continued when other wholesale changes occurred in 2015. However, prior to these changes there were limited options in terms of who could receive any pension upon a member’s death, and in turn limited scope in terms of how they could receive these funds.

To quickly recap, upon your death, the following options are available from most modern ‘money purchase’ i.e., non-final salary pension schemes:

If you die before age 75:

• The pot will pass down to your beneficiaries outside of your estate for IHT purposes
• Your beneficiaries can then draw on the pension pot as they see fit in line with their personal circumstances and free from Income Tax. For example;
  • They could draw the pot in one go
  • They could take ad-hoc or regular amounts as they see fit (or a combination)
  • They could leave the pension untouched and ultimately pass it to future generations upon their passing.

If you die aged 75 or older:

• The pot will still pass down to your beneficiaries outside of your estate for IHT purposes
• Your beneficiaries can then draw on the pension pot as they see fit, in line with their personal circumstances but anything drawn from the pension would be subject to Income Tax at their marginal rate as opposed to being tax free where death occurs prior to age 75.
  • Although anything drawn by your beneficiaries from the inherited pension pot on death after 75 is subject to Income Tax at their marginal rate – the key here is that they have the flexibility to draw down on the pension fund as and when they wish based on their own personal circumstances and income position and so have control over the timing of tax.

When the pension fund is inherited by your beneficiaries, the person(s) receiving it is subject to the 75 age rules. If they in turn pass the pension down again, the same rules apply as per the points above depending on whether they die before or after age 75.

A key consideration for someone receiving pension death benefits is whether to receive them as a cash lump sum or in the form of a pension fund called a dependent’s Drawdown. This will very much depend on individual circumstances, including age, reliance on the funds, Income Tax position and IHT position.

Often funds are left to a spouse and as such by receiving benefits in the form of a Drawdown plan, you are not introducing funds that would otherwise (if taken as a lump sum) be pulled back into the estate, and at risk of IHT at 40%.

It is also possible to “stagger” any Income Tax liabilities where death has occurred after age 75, whereas again a lump sum will create an immediate and potentially much greater tax liability.

It is important to highlight that not all pension plans or schemes offer this flexibility which is why we would advocate a review to ensure that any pensions funds – if not needed or utilised in your lifetime – can be used effectively to be passed on to beneficiaries very tax efficiently.

It is also important to remember as with any area of financial planning, there is no one-size-fits-all plan, and how pensions fit in with your overall strategy will be based on your own individual circumstances.

We have seen various options and planning opportunities used with pensions and their inheritability – for example missing the next generation and nominating grandchildren, who may be in greater need of the funds and potentially with lower incomes can often be extremely tax efficient. Another example would be the use of pensions to “level up” any inheritance – if a child is receiving a greater share of other assets such as property, the pension can be nominated to a different child to help bridge any gap.

We have also seen cases where current pension funds are nominated to a Trust. This can create additional tax liabilities as high as 45% and we would therefore suggest an urgent review to ensure this arrangement offers the best solution for dealing with the fund on death.

As with all financial planning, understanding the technicalities and the opportunities for your specific circumstances is key to ensuring the best outcome possible. To talk to one of our expert financial planners about ways to use your pension as part of your legacy planning, get in touch with us here.