Cutting the price of reassurance and control

Fellow pension geeks will have noticed that draft legislation was released by HMRC this week that means scheme administrators will have to report information to trustees where they make a payment of a lump sum death benefit to (non-bare) trusts. The draft legislation can be viewed here.

The new reporting requirements will ensure the pension scheme administrator passes on information to trustees regarding the 45% tax deducted at outset and the intention is that they will apply from 6 April 2016.

The trustees will provide further information to the beneficiary of the trust when a distribution is made. This is helpful because it will enable the beneficiary to reclaim a tax credit and means they only suffer tax at their marginal rate.

The changes to death benefits in 2015 have been well documented and the pilot trust option is often overlooked in the trust vs pension beneficiary debate. However, many clients have a desire to have some control over what would happen to funds after their death (often due to second marriage for example), so it is worth re-examining things in light of the new information requirements.

Let’s consider the example of Mrs Jones who passes away age 76 with a SIPP worth £300,000.

  • As she was over age 75 at death, any distribution would be taxable at the marginal rate of the beneficiary.
  • If the beneficiary is a pilot trust, this tax rate is a flat 45%.
  • Mrs Jones has chosen her trustees and briefed them well as to her wishes for the fund, and any desired beneficiaries.
  • The scheme administrator must therefore deduct a tax charge of £135,000, leaving a net distribution to the trust of £165,000.
  • Later in the year, the trustees make a distribution to the trust to Mrs Jones’ two sons of £35,000 each.
  • These sums are treated as having been subject to tax at the trust rate of 45% upon distribution.
  • So, although Mark and Roy each received £35,000 in their pocket and £70,000 has been deducted from the trust funds, they are treated for tax purposes as having received distributions of £63,636.36 each.
  • The difference of £28,636.36 is a tax credit in respect of the 45% tax paid by the scheme administrator when the lump sum death benefits were paid to the trust.
  • If Mark and Roy are higher rate tax payers, then their liability to tax on the distributions (40% of £63,636.36 = £25,454.54) is covered by the tax credit above.
  • They are also able to reclaim an amount of £3,181.81 each which represents the difference between their personal 40% tax liability and the 45% tax credit.

Compare this with the position if funds were designated to beneficiary flexi-access drawdown for both Mark and Roy (assuming they were eligible beneficiaries). An equivalent gross payment of £63,636.36 would result in a net payment to each of them of £38,481,82 after 40% Income Tax was deducted. If Mark and Roy were chosen as the beneficiaries, Mrs Jones could not have not stipulated that they subsequently designated the funds to a pension, or prevented them from spending them all at once!

The 45% initial tax charge on death benefits paid to a trust at outset can appear harsh when compared with funds being designated to provide a beneficiary’s pension which are only taxed at the marginal rate of the beneficiary on the date of receipt.

However, with confirmation from HMRC that the tax credit is reclaimable against a beneficiary’s own liability to tax when distributions are made from the trust, the price of reassurance and control (for the scheme member) looks considerably less.

Senior Technical Consultant

Charlene is a Chartered Financial Planner with over 10 years' experience in financial services. She joined AJ Bell in 2014 after relocating to Manchester from Bristol, where she held financial planner and paraplanner roles at leading firms. In addition to analysing and commenting on technical and regulatory issues, Charlene is also responsible for designing and providing technical training for AJ Bell staff.