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Pension death benefits - a new wealth transfer planning equation

Hello

2015’s ‘pension freedoms’ revolutionised the role modern, flexible DC pensions play in effective wealth transfer planning.

It’s easy to forget some of the detail, so over the next five minutes or so we’ll look at the key headlines - and what they mean for your advice.

Two headlines sum up the key game-changing pension death benefit reforms - less tax and more choice.

Firstly - less tax

• For deaths before 75, benefits are now paid tax free (within the LTA). Most people live beyond 75, but this tax-free treatment can make a real difference to the loved ones of the unlucky minority of clients who die young
• On death aged 75+, beneficiaries pay income tax on any death benefits they receive - when (or if) beneficiaries draw them.  Payments to a bypass trust will be taxed at 45%
• And remember, pension death benefits are typically free from IHT. For some clients, this means the ability to pass their wealth on via a flexible DC pension is super important

That leads on nicely to the second key change - more choice

This is the real game-changer when it comes to wealth transfer planning.

• Before 2015, only the client’s dependants could receive a survivor’s pension on their death.  Other loved ones could only receive a lump sum death benefit
• Now, any nominated individual can inherit pension wealth and keep it inside the tax-efficient pension wrapper as a drawdown pot. That means they have easy access to inherited pension wealth when they want - whilst keeping the undrawn pot outside their estate
• And it doesn't stop there. They too can nominate loved ones to inherit any remaining drawdown pot on their death - allowing this wealth to cascade down the generations outside the estate. 

The key words here are ‘nominated individual’. Unless the beneficiary is a dependant, these flexible options are only available if they’ve been named on the client’s death benefit nomination.

So, as well as the traditional role of letting the pension trustees know who the client wants to receive their pension death benefits, the nomination is now also crucial to keeping options open and providing flexibility to deliver the right outcome for their loved ones.

• These changes have re-written the wealth transfer planning equation
• But delivering the promise of less tax and more choice for your clients hangs on having their savings in the right pension with the right nomination in place - and keeping it up to date

Let’s look at the wider wealth transfer planning framework for modern, flexible DC pensions. 

Here's an overview of the key elements of the new planning equation:

To quickly recap on the tax position:

• Death before 75 - no tax on death benefits (within the lifetime allowance) - whether taken as inherited drawdown or paid as a lump sum. Funds above the LTA are subject to LTA tax as usual
• Death at 75 and over - the beneficiary pays income tax (45% for trusts) - when (or if) benefits are taken. Take a minute here to consider what this means. A lump sum payment can quickly eat up the recipient’s allowances, leading to high rates of tax. This is where having a nomination in place to facilitate inherited drawdown can make a real difference to the tax outcome
• And remember - inherited drawdown pots can be cascaded down the generations within the pension free of IHT. But the income tax position is reset each time it is passed on - based on the age at which the person it was inherited from died 

Charities

For clients with altruistic intent for their pension, there’s an option to bequeath a lump sum to charity tax-free - even on death after 75 - as long as they don’t leave dependants and have nominated the charity.

Moving on to IHT

• Pensions are normally outside the estate - protecting them against IHT. This makes them an important part of tax-efficient legacy planning.  But there are some planning pitfalls to look out for
• Firstly – Transfers. Most pension transfers won’t have any IHT implications. But leave it too late, and transfer in ill-health, and you may bring a pension that was outside the client’s estate back into the IHT net
• Secondly – Legacy pensions. Some older pensions are always in the client’s estate on death. In particular, look out for retirement annuity contracts (‘section 226s’) buy-out contracts (‘section 32s’) - that is, unless they’ve been written under trust

Paying to a bypass trust means a 45% tax hit upfront on death after 75 - and trust admin.

• But it gives more control over who gets what when – which can be a useful option for clients with more complicated family circumstances or complex needs

Gifting pension wealth can be an effective way of passing on a legacy during the client’s lifetime – so they can see loved ones enjoying the money

• Unused tax-free cash entitlement becomes taxable on death after 75.  So clients who don’t need the funds may want to consider gifting it before then.  Just be careful of the 7 year IHT clock on PETs – so don’t leave it too late.  And think about the tax-efficiency of the gifting strategy
• Gifts of surplus pension income, which can include regular withdrawals of tax-free cash, should normally be immediately outside the estate for IHT. Keeping appropriate records of each year’s income and gifts will help the executors claim the IHT exemption. They’ll use form IHT403 for this. But, again, consider the tax-efficiency of the gift destination

Taken together, this new planning framework can make modern, flexible DC pensions the family wealth management plan.

So, to sum-up the key wealth transfer planning considerations with flexible pensions:

Inherited drawdown

• Beneficiaries can access the funds at any age - in a way that suits them
• Inherited funds are never tested against the beneficiary’s LTA
• The beneficiary can cascade any remaining drawdown pot to their loved ones on death

Bypass trusts. They give more control over who gets what - and when

• But the extra control may come at the price of more tax
• Bypass trusts still have an important role to play in effective wealth transfer planning for the right clients - but it’s more niche than before 2015

Nominations are key to delivering the right outcome

• But pre-2015 nominations are unlikely to still be appropriate in a world of pension freedom
• Review nominations regularly - as a routine part of your annual client review - to ensure they stay appropriate as circumstances change
• Revisit older nominations to bypass trust as a priority - is it still fit for purpose.
• And always revisit nominations at 75, when the tax treatment changes

There’s no time like the present - now is the time to revisit death benefit nominations and income strategy

And finally, the key advice points hang on our Mantra

Right pension, with the right nomination, at the right time.

Right pension

• Are your clients’ savings in modern, flexible pensions?
• Do they give all the death benefit flexibility they need?
• Consider consolidating older pensions if they don’t.

Right nomination

• Review existing nominations to check they support the right outcome in a world of pension freedom
• Always name non-dependent beneficiaries on the nomination, so they have the option of inherited drawdown
• And revisit nominations regularly to ensure they stay up to date as circumstances change - and always at 75

Right time

• Dying in the wrong pension, or with the wrong nomination, may mean your client’s wishes can’t be met - potentially leaving you with some awkward questions to answer

• And don’t leave it until health starts to fail and IHT becomes an issue - remember, transfers in ill-health can have IHT implications

Get your clients’ pensions in shape for every eventuality - now.

This presentation is based upon Standard Life's understanding of UK law and HM Revenue & Customs practice in the UK at the date of recording.

Tax and legislation are likely to change.

This presentation is designed as educational support for authorised advisers and should not be relied upon by anyone else.

Tax treatment depends on individual circumstances.

No guarantees are given regarding the effectiveness of any arrangements entered into on the basis of this presentation.

This content provides a suggested approach only – other approaches may be equally suitable. Every client's circumstances will be different and require advice.

Standard Life accepts no responsibility for advice which may be formulated on the basis of this presentation. Any advice you give is your responsibility.