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Favourable tax rules allow transfer of wealth
Thursday 15 Dec 2016 Author: Emily Perryman

It’s hard to think of your pension as being anything other than a vehicle to fund your retirement, but it can also be a good way of passing wealth on to your children while reducing your tax bill.

In April 2015 the dreaded 55% ‘death tax’ on pensions was abolished, enabling pension benefits to be paid out tax-free to family members in certain circumstances.

Most people want their spouse or partner to inherit their pension in the first instance, but if you’re single or your spouse doesn’t need any of your pension, you can pass it directly to your children or grandchildren.

Tax rules

If you die before age 75, the remaining funds in a drawdown pension can be paid out either as a lump sum or as continuing income without any tax deduction whatsoever.

If you die after age 75, the recipient will pay income tax at their marginal rate when they start drawing money from the pot.

There are no restrictions on how much of the pot the beneficiary can withdraw at any one time. They can take it as a single lump sum or use it to buy an annuity or adjustable income.

The beneficiary could leave their inherited pension to grow alongside their own pension to boost their income in retirement.

If they need income earlier, they could draw down as much or as little as they need from one year to another. If the beneficiary leaves the pension pot intact, it could be ‘cascaded’ down further generations.

As well as being a key part of estate planning, the legislation around pensions on death makes them a useful tax mitigation tool.

Steve Patterson, managing director at Intelligent Pensions, says if you have a large pension fund as well as a big personal estate with investments or cash, it might make more sense to spend your personal capital rather than your pension capital. This would lower the value of your estate and reduce the amount that would be liable to inheritance tax (IHT).

‘Take someone with a £1 million pension fund and a £1 million personal estate, including their home. The current threshold for IHT is £325,000 per spouse. Therefore, for a married couple, anything in excess of £650,000 would be taxed at 40%.

‘In these circumstances, given the choice between spending personal money or pension money, it may make sense to spend the personal money (even if that depletes the capital) and allow the pension fund to grow instead. And if the personal capital is eroded to a level that becomes uncomfortable, you can then start drawing from your pension plan,’ explains Patterson.

Money matters1

Lump sum

It’s important to think about whether you need to withdraw your 25% tax-free lump in retirement.

Martin Tilley, director of technical services at Dentons Pension Management, points out that if the money continues to be held in a pension any growth will be tax-free.

If you withdraw it, the money will form part of your estate and could be subject to IHT. The same is true whether you take your whole tax-free portion in one go or take it in chunks.

An exception to leaving your tax-free lump sum intact is if the intended recipient is likely to be a 45% taxpayer.

Andy James, head of retirement planning at Towry, says in these circumstances paying IHT (at 40%) is a better option. However, he points out that the beneficiary could hold the pension until a later date when their tax charges might fall.

‘For a 40% taxpayer the cost of either option is neutral but could still favour the pension option owing to the continued inheritability of the successor’s pension outside of any estate. Where the individual is likely to pay basic rate or zero tax then keeping the funds within the pension would normally prove beneficial,’ he adds.

Adult hand passes a baton topa child's hand.

Choose your beneficiaries

It’s important to ensure your pension goes to the individual(s) you want it to.

Most pensions are set up under trust to avoid IHT, giving the trustees discretion over who receives the benefits when you die.

You can tell the trustees who should receive your pension by completing a death benefits nomination and expression of wishes form.

‘It is then the duty of the trustees to take into effect the client’s instructions and any other relevant information, such as a will, in the exercise of their discretion. It is therefore imperative to keep such forms up to date and reflective of changing circumstances and wishes,’ says Mike Morrison, pension expert at AJ Bell.

When completing the form you mustn’t take away the final discretion of the trustees in deciding on the payments. Otherwise, this could make the death benefits part of your estate and subject to IHT.

Investment choices

Even if you have earmarked your pension as a pot to pass on down the generations this shouldn’t dictate your decisions over which assets to invest in.

Tilley points out that circumstances change and unforeseen issues might make it necessary for you to use your pension savings for your own needs, for example if care costs escalate.

First and foremost, your pension should be viewed as something to provide an income in retirement, with any residue being passed on.

‘The make-up of the investment portfolio should reflect the income needs and investment profile of that particular individual. The investment mix can be changed by the beneficiaries once they have inherited the pension if they wish to do so based on their own needs,’ Morrison explains.

Seek financial advice if you are unsure about inheritance tax rules

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