The ages of wealth

  • Author : Alistair Cunningham
  • Date : April 2013
ABOUT THE AUTHOR: Alistair Cunningham is Financial Planning Director at Wingate Planning and an Affiliate of STEP

By my reckoning the UK tax treatment of pension benefits has changed six times in the past seven years. I often hear the tax position of pension lump sum death benefits (LSDB) on death described as being ‘free of inheritance tax’ (IHT). This is a dangerous oversimplification, and while many pensions, including company life assurance plans written under pension rules, enjoy privileged status, there is a variety of plans, and a different client situation could lead to a different outcome and thus require different recommendations.

Pension jargon is rife; frequently life insurers, pension providers and financial advisors will all use different words to describe the same thing. For example, in determining the treatment of death benefits, it is important to distinguish whether an LSDB has paid any retirement benefits. In this situation, pension benefits might be referred to as unvested, uncrystallised, pre-pension or pre-retirement. Despite the difference in nomenclature, the status is the same: neither pension commencement lump sum (PCLS – ‘tax-free cash’, as it was known) nor income has been taken.

In assessing the tax treatment of LSDBs there are several variables to consider. In this article I look at inheritance and income taxes, but note that there is always the potential for lifetime allowance (LTA) charges. Broadly speaking, an individual can accrue only GBP1.5 million of pension benefits before tax potentially falls due. Various protections were available for those with greater levels of benefits (in 2006 and 2012), and it is proposed to reduce the LTA further to GBP1.25 million in 2014. Any lump sums paid on death in excess of this will usually be taxed at 55 per cent. Due to the broad range of planning and protections available, this is a complex area. Encouraging clients to seek professional advice if they are in excess of, or approaching, these limits is important. Lump sum and money purchase (or cash balance) benefits are assessed based on the value paid out, whereas scheme pension arrangements (principally ‘defined benefit’ dependant’s pensions) are not tested against the lifetime allowance on death; but in life they are assessed against the LTA with a 20x multiple, with any lump sums added on top. Unless otherwise stated, the examples below are for money purchase death benefits.

Before age 75, and before taking benefits

An uncrystallised LSDB should normally be paid to beneficiaries within two years of the reported death. The nature of the scheme will define the rules that govern these payments, but most trust‑based schemes will have discretion as to whom benefits can be paid. However, the nature of the scheme should be verified, as not all schemes have discretion.

‘Retirement annuities’ and ‘section 32’ policies (commonly known as buyout bonds) are contract-based rather than trust-based. Although they are rare, I have also come across pensions that have been established through board resolution or deed poll – accordingly no master trust exists, and while one would hope the administrator has trustee-like discretion to choose to whom benefits are paid, this may not always be the case.

Use of trusts for IHT mitigation

For trust-based pensions (most occupational and personal pensions, including self-invested personal pensions (SIPPs) and stakeholder plans) a pilot trust can be the nominated beneficiary of any LSDB. It is held that the pilot trust is a related settlement (s81 of the Inheritance Tax Act 1984) to the original pension fund, so an advisor must look back to any ceding pension schemes for both the ten-year periodic charges and the number of nil rate bands applying. Although I’ve seen contention over the matter, it seems that HMRC’s interpretation of s81 is that splitting one LSDB across several pilot trusts is not effective for reducing period charges, but a GBP1 million pension pot ceded from five smaller trust-based schemes (as opposed to contract-based, as above) could have up to five nil-rate bands.

For deed poll or board-resolution-based schemes (the minority of personal plans), an assignment to trust or nomination to a pilot trust should work. Verification of the preference of the scheme administrator is advisable. Insurance contracts can only be assigned to trust, and failure to do so would mean that the policy would fall back into the policyholder’s estate. As a contract between the policyholder and the insurance company, there is no discretion on death, and IHT could apply.

While the above defines what is technically possible, scheme rules may vary. Most trust deeds, scheme rules and any irrevocable directions to the scheme should be written to avoid a general power of disposal – the ability of the deceased to require death benefits to be paid to their estate – to avoid IHT. As has been observed on the STEP Trust Discussion Forum, not all schemes allow nomination to trust – the NHS scheme and the new workplace pension ‘NEST’ are two examples.

Before 75, but after taking benefits

Crystallisation of benefits is not an absolute. For example, many individuals choose to phase their retirement benefits so one pension, with one plan number, may consist of both crystallised and uncrystallised benefits. The rules also changed significantly on 6 April 2011, so I will consider only those who die after this date.

Annuity

Any dependant’s annuity will be free of lifetime allowance charges, and would be set at no more than 100 per cent of the pensioner’s annuity. However, it is possible to ‘purchase’ ancillary options, which would normally reduce initial income, with a corresponding death benefit:

  • Guaranteed period. It is possible to ensure that, irrespective of whether the annuitant or their dependant is alive, the income continues for up to ten years. This would not be subject to IHT where the scheme trustee has discretion as to whom this is paid, but there are two principal complications. First, an ‘open market option’ annuity (as opposed to an immediate vesting pension) would be purchased under the original scheme rules, not the rules of the insurance company paying the annuity, and second, not all annuity providers will exercise their discretion. Income tax under PAYE will be due by the beneficiary.
  • Value protection. Similar, but rarer than a guarantee, it is possible to ensure that a specified minimum total capital value is paid by the insurer. For example, for a GBP100,000 purchase price and 50 per cent value protection, a lump sum would be paid if the annuitant (and any dependant, if relevant) died before the protected (GBP50,000) sum was cumulatively paid out. Again, no IHT is due if the payment of the value protection is subject to discretion, but a flat 55 per cent income tax charge is levied on the death benefit.

Capped and flexible drawdown are treated in the same way for death benefits, though as any individual that can elect flexible drawdown can take their entire fund out, paying at most 50 per cent income tax (45 per cent from 6 April 2013, and ignoring lifetime allowance issues) there’s arguably more planning available to these individuals. In particular, the ‘gifts from normal expenditure’ exemption may apply.

“A pot ceded from five smaller trust-based schemes could have up to five nil-rate bands”

On the death of an individual in drawdown, a beneficiary can elect to have the fund as a lump sum, minus a 55 per cent tax charge, or a financial dependant can continue drawdown or scheme pension (detailed below), or purchase an annuity. If they elect drawdown they have a two-year window from the date of death to choose another option.

Scheme pension

Most commonly associated with defined benefit schemes, it is possible to pay a scheme pension from any fund that is set up as under a bespoke retirement trust. An example would be an occupational small self-administered (SSAS) scheme, but it is also possible to set up a SIPP on this basis (colloquially referred to as a family SIPP).

Like an annuity, a dependant’s pension can be provided under a scheme pension. It is also possible to provide value protection and a minimum scheme pension period, just like under an annuity. The tax implications are the same, and most schemes will be written with discretion over benefits to avoid IHT.

Unlike a drawdown plan, which is commonly under a master trust arrangement where all members of the same scheme are under the same trust (albeit earmarked, notionally segregated accounts), the private nature of the bespoke trust under an SSAS or family SIPP allows the trustees to commit to a fixed-scheme pension that is funded from a collective pool. This allows actuarial surpluses to accrue, which can be used for funding lean years (either due to poor investment returns or unusual longevity of the pensioner), but should the member die this surplus can be used to supplement other members’ benefits, pay scheme fees or even act as an LSDB (with potential additional tax charges). A scheme pension may be especially appealing for those with money purchase benefits approaching or above the lifetime allowance.

Post-75

All LSDBs (with the possible exception of excesses under scheme pension) will be subject to tax at 55 per cent, with the income from dependant’s pension and guarantees treated as at early ages. The 55 per cent applies to crystallised and uncrystallised benefits, including any PCLS that is due, so it is normally good to take this benefit no later than 75.

Other considerations

Despite the detail above, I cannot cover all scenarios. Specifically, I’ve not covered unapproved or offshore pension schemes, or quirks in scheme rules that can override what is permissible. From 6 April 2012, ‘protected rights’, so-called as they came from opting out of the second state pension, have ceased to exist, making many individuals’ positions simpler. However, pre-6 April 2012 estates may have protected rights, and contracting-out benefits still exist in some occupational schemes – these are potentially IHT-taxable.

Planning in the knowledge of ill health can also result in IHT falling due. Pension contributions are now restricted to much lower levels than before, but in the event of death in two years of contributions or transfer of benefits, IHT may fall due. If a member is in good health, this would normally not be subject to IHT, but if in ill health there may be a transfer of value and IHT could apply.


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