The ability to draw your pension fund flexibly (to purchase the often quoted Lamborghini), has been well publicised.
Flexibility over death benefits is a lesser-known advantage of pension freedoms. It used to be almost impossible to pass on pensions to the next generation, with taxes of up to 82% applying to the fund in some cases.
It is now possible to pass on your pension fund as you wish, free of tax in most cases.
This is a significant improvement and has resulted in many planning opportunities. Pensions have become just as valuable as an estate planning tool as well as a vehicle for retirement.
Before Age 75
If you die before age 75, your pension fund can be paid out as a lump sum to your chosen beneficiaries, with no tax deducted. It doesn’t matter if you have taken benefits or not.
The situation is different if you have an annuity or a scheme pension and certain other types of pension. These do not usually provide a lump sum (although the first few years’ payments may be guaranteed), but could include a spouse’s pension. This will depend on the contract at outset. If you buy an annuity without a spouse’s pension, it is not possible to add one later.
After Age 75
If you die after age 75, you can still pass your pension on to your desired beneficiaries. The funds will remain inside the pension wrapper, to be drawn as required. They can draw can draw the entire fund if they wish, but will pay tax of up to 45% on the value.
They may find it more efficient to:
- Draw it over time at lower rates of tax,
- Preserve it for their own retirement, or;
- Pass the fund on to their own children.
Inheritance Tax (IHT)
Inheritance Tax is not usually payable on pension funds. Each individual has a nil rate band of £325,000, which is the value of assets that can be passed on without IHT. Transfers to spouses are exempt, and a surviving spouse can inherit the nil rate band of their deceased husband or wife. This means that a couple can bequeath assets valued at £650,000 without any IHT liability.
This can be increased by £300,000 (resulting in a total nil rate band of £950,000) if:
- One of the assets is a family home,
- It is being passed to a direct descendent, and;
- the total estate is valued at less than £2 million.
Where you have assets valued at over the nil rate band, passing a pension fund to your children on first death can be very efficient. Your spouse still has the full joint nil rate band to apply to their own estate, and the pension fund does not need to factor into the IHT calculation.
Setting up a Trust can allow even greater flexibility, as both your spouse and children (and any other beneficiaries you wish) can receive some of the benefits. The advantage is that the fund is not included in anyone’s estate. This is a complex area, and legal advice should be taken. Trusts can end up paying higher amounts of tax than individuals, so this needs to be taken into account.
If you are in poor health and transfer your pension to a plan with more flexible death benefits, HMRC may challenge your estate, and potentially charge IHT, if you die within two years.
Once you have decided that pensions are the best option for your estate plan, you need to decide how much to contribute. Anyone can contribute up to £3,600 per year into their pension fund. This only costs £2,880 from income, as the government will credit the remaining 20% directly to the fund. You can even contribute for a child if you wish. Higher and additional rate tax-payers can claim further relief.
Higher contributions may be possible, but this will depend on several factors:
- Your earnings
- Whether the contributions are made by you or by a business
- Whether you have already taken benefits from your pension
- Whether you have used your full allowance in previous years
This can be complicated, so advice is recommended if you are unsure how much you can contribute, particularly if you are a high earner.
In general, gifts of up to £3,000 per year, per individual donor, are immediately exempt from IHT. This includes contributions made into someone else’s pension fund.
Larger gifts may also be exempt in certain circumstances.
In most cases, pension contributions allow a higher amount to be removed from the estate over a shorter period of time. Keeping the money in your own pension also allows you to retain control of the money.
- Pensions are a highly efficient way to pass on assets to the next generation without Inheritance Taxes.
- Up to £1,055,000 can be passed onto beneficiaries without tax being deducted on death. For a couple this is doubled to £2,110,000, if the spouse has also funded their pensions.
- This is in addition to £950,000 of non-pension assets that can be passed on without Inheritance Tax being deducted.
Pensions are not always the best option for IHT planning. For example:
- If your pension fund exceeds the Lifetime Allowance (currently £1.055 million), the excess will be taxed at 45% to 55%, depending upon how the excess is drawn. This far outweighs any IHT benefit. A balancing act is required.
- Pensions are not always efficient for making lifetime gifts. While this may not be your intention, plans can change. You cannot access your pension funds until age 55. You can then draw a tax free lump sum of 25% (which could be gifted). Any withdrawals thereafter are taxable at your marginal rate.
- When you die, the pension company Trustees will have discretion over the payment of your pension benefits. In most cases, they will take your wishes into account. If you intend to leave your pension fund to your spouse and/or your children, there will usually be no issue. If you have a different plan, there is no guarantee that the Trustees will uphold your wishes.
- Pensions are often a target for changing legislation. What works now, may not work in ten years.
Top Tips for Using Pensions in Your Estate Plan
- Ensure your Will and Expression of Wishes are up to date.
- Check your IHT calculation. With a potential nil rate band of up to £950,000, IHT may not be such a concern.
- Make use of your gifting allowances.
- Use pensions as part of a wider estate planning strategy, rather than in isolation.
- Consider Trusts for larger-scale asset sheltering.
- Look into other investment options, such as those qualifying for business property relief (a 100% exemption from IHT if held for at least two years).
- Always obtain advice. Estate planning strategies work best when financial planners, lawyers and tax advisers co-operate.
- Review your plan regularly in case of changing legislation.
Please do not hesitate to contact a member of the team if you would like to find out more.