Listen to this article
Using a pension to pass retirement wealth on to younger generations has become more attractive, thanks to pension reforms that came into force this year.
Until just a few months ago, in the UK it was only possible to pass on a pension pot to heirs without being subjected to a punitive “death tax” if you died before age 75 and had not touched the funds.
If you had drawn on your retirement pot, or were aged over 75, then a little more than half, or 55 per cent, of the fund would be subjected to tax.
But wide-ranging reforms introduced in April mean there is now greater opportunity for an entire pension pot to pass through the generations, or to other beneficiaries, tax free — or at a less punitive tax rate.
Wealth managers say the changes, introduced by the UK Coalition government, have been welcomed by those looking for inheritance tax planning opportunities.
“This had been an area of great concern in the past but clients now see an advantage to leaving their pension funds in place, rather than consuming them as rapidly as possible,” said Paul Taylor, founder of McCarthy Taylor, chartered independent financial advisers.
“Coupled with the changes in income drawdown this makes pensions a highly effective inheritance tax tool.”
Under new rules, if the pension fund holder dies before age 75, a beneficiary can inherit some or all of the fund as a lump sum, or income from drawdown, tax free, up to the Lifetime Allowance, currently £1.25m.
If the death is at, or after, age 75, any beneficiary receiving a lump sum will pay 45 per cent tax until next April, or tax at their marginal rate, if the fund is paid as income, not a lump sum.
After April 6 next year, the pension pot that is inherited will be taxed at the recipient’s marginal rate.
Wealth managers say the reforms are changing how individuals tap into their assets in retirement.
“These changes have really turned tax planning on its head,” says Nick Gartland, senior financial planning director with Investec Wealth Management.
“Under the old regime, there was a trend towards actively running down assets in the pension fund after 75, but there’s now been a move towards running down cash in other assets first, such as Individual Savings Accounts, or Isas, before the pension.”
“If the client wants to pass their fund on to the next generation, there is less need to run the pension pot down.”
Advisers say the changes are providing an incentive for savers to cash in their defined benefit, or final salary, arrangements, which are not covered by the changes.
“Some individuals with deferred defined benefit pensions (other than unfunded public sector schemes) might find it more attractive to transfer the cash equivalent transfer value of those rights to a self-invested personal pension, in order to increase the potential death benefits and/or potentially lower the taxation of lifetime and post death benefits,” says Jason Butler of Bloomsbury Wealth Management.
However, not all pension policies are covered by more death tax changes.
The changes fully apply to income drawdown policies, such as self invested personal pensions, capped drawdown or flexi-access drawdown, but only partially extend to annuities.
“This has certainly driven a lot of business away from annuities,” added Mr Gartland.
Only annuity policies where the policyholder has opted for value or capital protection, which comes at a cost, will be covered by the death benefit changes.
Otherwise, any residual funds left in an annuity pot when the annuitant dies will pass to the insurer.
Changes that also came into force this April mean a policyholder has full freedom to designate who benefits from their pension pot.
“It used to be spouses and dependants were the only people who could enjoy the pot — but now it’s anyone you nominate,” says Mr Gartland.
Advisers say that it is now important for policyholders to ensure the intended beneficiaries of their pension wealth are named on the death benefit nomination declaration.
Mr Gartland adds that it is essential that pension members regularly update their death benefit nomination forms and name every beneficiary.
“Although the scheme administrator can appoint a nominee or successor to receive death benefits, it can only do this if there are no financial dependants entitled to benefits,” he adds.