For most people it is an essential part of their overall financial planning strategy to be able to pass their hard-earned wealth onto future generations. Historically, this had been difficult as many pension schemes would provide an income for life but only limited benefits for the spouse or certain dependents. However, for most modern pension funds, particularly since the changes in legislation on 6 April 2015, passing on pension funds can be incredibly tax efficient.
It is important to be aware of the options each particular pension contract offers as some older pensions may still not allow full flexibility. In particular, final salary or defined benefit schemes will typically only provide specified benefits to spouses or dependent children. In addition, should an annuity be purchased, this will typically also offer similar benefits.
For money purchase schemes, the treatment of any remaining value on death depends on the age of the member:
- Death of the pension scheme member before 75 allows for full pension capital to be paid out to beneficiaries without tax, regardless of their personal circumstances*.
- On death after the age of 75, there is no tax on the pension capital being designated to beneficiaries, but they must pay income tax at their marginal rate on any funds they wish to withdraw.
As funds may be drawn via flexible drawdown in the latter scenario, beneficiaries are able to tailor their withdrawals to suit their own needs and tax circumstances. Should they already have significant incomes, they may choose to defer withdrawal until it is more tax efficient to do so, allowing the pension capital to continue to grow in a tax-free environment.
Although annuity purchase has seen a resurgence in popularity, with higher interest rates driving higher headline rates, it should be noted that this option does involve surrender of capital. A guarantee period or spouses/dependent pension can be built into the contract at outset, however, there would be no benefit to wider family outside of this. In addition, once the annuity is purchased, options cannot be typically changed and therefore the spouse’s pension may provide poor value if the spouse predeceases the annuitant.
In addition, as highlighted above, certain older pension contracts will not allow retirement to be delayed past 75. Accordingly, should this be desirable from an overall planning perspective, including the ability to retain funds for inheritance, it may be necessary to consider a transfer of such pensions to a more flexible contract.
Under current legislation an individual who inherits a pension fund would subsequently provide their own nomination for these funds. As such, at present, pension capital can cascade to a family tax free on death with tax only applicable to income drawn on funds passed on after the age of 75. In addition, it is worth noting that should a beneficiary receive inherited pension capital from an individual over the age of 75 they would pay income tax on any withdrawals they choose to make - but should they subsequently die prior to the age of 75 their own beneficiaries would be able to access the fund free of tax.
Naturally careful consideration should be given to the type of pension scheme utilised, with more flexible arrangements such as self administered pensions potentially offering flexibility, and adding and removing members through the generations to achieve this objective.
Since 6 April 2006 (known as ‘pre A-Day’) there has been a cap on the overall level of pension savings each individual can accrue tax efficiently, known as the lifetime allowance (LTA). Where funds are accrued in excess of this, additional tax can apply. As such, consideration may need to be given to withdrawing pension benefits to control the level of capital that accrues, although in many cases any additional taxation within the pension environment may be still preferable to inheritance tax and personal taxes such as income tax and capital gains tax (CGT). In the recent budget it was announced that the LTA will be removed but we await detail via the relevant finance act and in some cases consideration may still need to be given to the level of pension benefits accrued.
It should also be noted that once pension capital has been designated to a beneficiary it is theirs to control. As such, it is not possible for the original pension member to control or restrict access which can be particularly important when considering leaving funds to younger family members such as grandchildren. In addition, as noted above, each beneficiary is free to nominate their own successor and therefore, consideration will need to be given to these areas. In some cases it may be beneficial to consider the use of a bypass trust to receive some or all of the pension benefits but maintain an aspect of control.
Finally, we should always bear in mind that pension schemes are first and foremost designed to provide retirement income. Where other assets are providing more than sufficient income, one approach may be to forgo income from the pension scheme in order to maximise the value of this asset outside of the estate. However, in some scenarios it may be preferable to utilise pension income to replace income from personal assets which can then be gifted or placed into trust. In doing so, it may be possible to reduce an individual’s estate more than would otherwise be possible including the potential to reclaim any lost residence nil-rate band (RNRB) for those estates exceeding £2 million.
Modern pension schemes offer an excellent opportunity to pass wealth tax efficiently through the generations. However, as with any financial planning this should form part of an overall strategy and we must be mindful of the potential for future charges around personal circumstances or legislation which may impact planning. As such, should you wish to discuss your own position, please do not hesitate to get in touch with a member of our consultancy team.
* Individuals in non-UK jurisdictions should seek local tax advice.
All content correct at time of writing.