Commentators on the new pension rules which are due to apply from April have concentrated on the opportunities for pensioners to make withdrawals from their pension pots as they please. However, the new pension rules also offer the opportunity to pass on family wealth without paying Inheritance Tax (“IHT”).
In this instance, we are only talking about “defined contributions” pensions; roughly speaking, this is where the contributor pays in a certain amount and then his pension depends on the value of his pension pot at retirement, which in turn depends on how successful his investments have been. This contrasts with “defined benefit”, or “final salary” schemes, where the benefit is fixed and it is up to the pension scheme administrators to make sure there is enough in the pot. In these cases, what benefits are available to the families of deceased scheme members depends on the rules of the individual scheme.
The current rules are that if you die before making any withdrawals from your pension pot, whatever is in the pot can go to your beneficiaries tax free. When you start taking a pension (and you must do so by the age of 75) then you can have up to 25% of the pot in your own hands tax free. For most people, the rest of the pot must be used to buy an annuity and although many annuities guarantee to pay out for a minimum period (even if the annuitant dies within that period), for the most part, when the pensioner dies, apart from the possibility of a reduced annuity for your spouse, there is nothing to pass on to their family. Within strict guidelines, it is possible not to buy an annuity but simply to make drawdowns from your pot. In this case, anything which is left on your death can pass to your family but Inheritance Tax of 55% must be paid.
So, although the income tax relief on contributions to pension schemes is very appealing, the restrictions on getting money out, the prospect of the loss of all the funds after age 75, or the tax charge of 55%, makes them unattractive as a vehicle for passing on wealth to your family.
All this is now changing. With effect from 1st April 2015, there is no obligation to take a pension when you get to 75. When you want to take a pension, you can withdraw 25% of the pot tax free as now. You can then make any further withdrawals you wish, up to the whole value of the fund, but you will pay income tax on those withdrawals at your marginal rate. If you die below age 75, whether you have been taking a pension or not, whatever is in your pot at death can pass to your family tax free, either inside or outside the pension wrapper. If you die after the age of 75, then (again, whether or not you have been taking withdrawals) whatever is in the pot can go to your family tax free but if they take out the pot as a lump sum then there is a tax charge of 45%. Alternatively, your nominated beneficiaries can make ordinary pension withdrawals from the funds (once they have reached the age of 55), and pay income tax on those withdrawals in the ordinary way.
All these provisions are subject to a maximum pension pot allowance of £1.25m per person, although if you inherit a pension pot, this will not count towards your allowance. In terms of income tax relief on your pension contributions, these apply up to an amount equal to your earnings in the relevant tax year, up to a maximum of £40,000.
The effect of these changes is to make pensions very attractive as part of your IHT mitigation strategy. You will get income tax relief on the payments in, and have access to the funds once you reach 55. If you die before 75, the remaining funds can go to your family tax free and if you die after 75 (which is more likely) then your beneficiaries can withdraw the funds in such a way as to minimise the tax. We do have clients whose children struggle to manage money and if they are non- or basic rate taxpayers then the advantages of leaving the money in the pension and making regular withdrawals may encourage them to leave the money where it is and to use it to supplement their income in middle- and old age.
Pensions are not at the glamour end of tax planning but like so much that is unglamorous, they provide solid benefits that everyone should consider.
Myerson Solicitors LLP provide specialist advice relating to wills, probate, probate disputes, inheritance tax planning and powers of attorney to clients in Manchester and Cheshire.