Pensions vs Inheritance Tax

Pension freedoms have been here for two years now, but their effects are still filtering through into other areas of financial planning - here Martin Jones looks at what role they can play from an IHT perspective.

While the freedoms mostly caught the eye for the ability to take benefits free from caps, there were also important rule changes that make pensions attractive for other reasons.

As advisers will know, trust-based pensions fall outside a client’s estate, which means they are normally exempt from inheritance tax (IHT). Yet this hasn’t always been a primary motivator in advising clients to put funds into a pension.

Two factors might now cause a rethink. Firstly, the news that IHT receipts are at their highest level since IHT's introduction in 1986, which is pushing IHT back up the agenda. Secondly, the change in the taxation of pension death benefits.

Before April 2015, death benefits could be distributed as a lump sum or as a pension. Lump sums could be paid to anyone. However, pensions could only be paid to individuals who qualified as a dependant as defined in legislation. This included spouses, children under 23 and individuals with whom the client was in a relationship of mutual financial dependence (partner cohabitees, for example).

If paid as a pension to a dependant, this was essentially the end of the line for those funds as far as the pension wrapper was concerned. If the dependant died, any remaining funds would be distributed as a lump sum to other beneficiaries, thereby bringing the funds into their estates for IHT purposes.

In 2015, two things changed.

Firstly, death benefits could be paid in the form of a pension to a much wider range of individuals, specifically ‘nominees’ and ‘successors’. A nominee is anyone nominated by the client. A successor is anyone nominated by a dependant or nominee. (The dependant option is still there and the definition remains broadly unchanged.)

This explicitly opens up the possibility of funds being kept in the pension environment, therefore outside the clutches of IHT, and cascaded on through generations.

Secondly, the tax treatment of death benefits changed, and for the better. Before 2015, lump sum death benefits were taxed at 55% if the funds were crystallised or if the client was over 75. Now, death benefits are generally tax-free if the client dies before 75, and they are only taxed at the recipient’s marginal rate if the client is 75 or over.

There is no minimum withdrawal amount on a dependant’s, nominee’s or successor’s drawdown fund, so even if income from those funds is technically subject to income tax, the recipient has some scope to mitigate the actual tax paid – for example, taking only as much income as is needed or just up to the income tax personal allowance.

The change in taxation means there is now more incentive to keep funds within the pensions environment for as long as possible. And the change to rules on nominations means this is a lot easier to achieve. As such, there is now a lot more scope to use a pension to achieve positive outcomes from an IHT, estate or intergenerational planning perspective.

Technical Team Leader

After completing his postgraduate studies at Lancaster University, Martin spent two years working for a leading insurance company before joining AJ Bell in April 2007. Martin worked initially on the AJ Bell Investcentre product before moving to a technical role in 2009. His main focus is providing technical support to the various teams and departments within the business. He is also involved in delivering training to staff on the rules and regulations that affect our customers.