A cross in a graveyard showing the letters R I P...AAA5A7 A cross in a graveyard showing the letters R I P
© FT

The pensions revolution continues. The industry was taken by surprise this year, when George Osborne, the chancellor, announced in his Budget speech that the effective requirement to buy an annuity was to be abolished in April 2015. Now, Mr Osborne has acted to remove another anomaly in the pension system, and in so doing has gone much further than most observers expected.

It was known as the “death tax” – a 55 per cent charge on whatever is left in a pension pot if it is bequeathed. The government pledged to review the levy as part of the Budget changes, and was expected to announce its conclusions in the forthcoming Autumn Statement.

Many experts thought he would reduce the charge to 40 per cent, the same level as inheritance tax. Instead, Mr Osborne announced at the Conservative party conference this week that the 55 per cent tax on whatever is left in a pension pot when someone dies is to be abolished completely.

The rules remain fairly complex. FT Money answers some of the most common questions.

Does this change apply to all types of pension pots, such as final salary?

No, the measure only applies to “income drawdown” pension funds and to “value-protected” annuities. Income drawdown is when pension savings are left invested at retirement, rather than exchanged for a secure income in the form of an annuity.

“Value protection” is a type of money-back guarantee that can be bolted on to an annuity for a fee. It allows some money to be repaid in the event of premature death.

The tax changes do not apply to final salary (sometimes known as “defined benefit”) pensions.

How will the changes work for income drawdown?

Currently, when a person aged 75 or over dies, a 55 per cent tax is levied on what is left in the pension pot. A 55 per cent tax is also applied when someone under 75 dies, if their pension pot is already in a drawdown account. Only spouses and financially dependent children under the age of 23 are exempt from the 55 per cent tax, paying an income tax at their own marginal rate when they draw down the pension.

In future, if someone aged 75 or over dies while in drawdown, all beneficiaries will only have to pay their marginal income tax rate on income, with the 55 per cent rate abolished. However, an inherited fund taken as a lump sum, rather than income, will incur a tax charge of 45 per cent.

When an individual under the age of 75 dies, their pension pot can go tax-free to any beneficiary they have nominated, even if the pension was already in drawdown. There will be no tax when the pension is passed on and the beneficiary will not have to pay income tax on the money they withdraw from the pension.

I have an annuity? How will the changes affect me?

The rules are the same for drawdown but only apply to “value-protected” annuities. Value protection allows an individual to pass on a portion or all of their annuity fund to a beneficiary should they die earlier than expected. Currently, the tax on value-protected lump sums is 55 per cent but from April 2015 the tax will be zero if the annuitant dies before they reach age 75 and at 45 per cent from the age of 75. From April 2016, the beneficiary’s marginal rate will apply on inherited annuity lump sums.

Retirement savers who do not have value protection on their annuities will not benefit from these rule changes. The insurance company keeps the annuity pot when the customer dies.

When do the changes come into force?

The changes will apply to all payments made after April 6 2015. However, the beneficiaries of anyone who dies before April 2015 can still benefit, so long as payment is delayed until after that point. Given the amount of time it can take to settle an estate, that should not be difficult.

The changes are subject to final confirmation in the Autumn Statement on December 3.

If I am a beneficiary of a pension fund, what should I do?

The government has indicated that people in this situation can benefit from the new rules if they are able to delay taking payment of the inherited pension until April next year. Doing so could save thousands of pounds in tax.

Will my provider give me the option of taking the income?

There is no certainty on this, as pension providers do not have to incorporate the government’s rules to their business models. Some providers may not offer the drawdown option to beneficiaries, meaning they will be left with little option but to pay a 45 per cent tax on a lump sum (assuming they cannot delay taking their inheritance before April 2016, when lump sums will be taxed at their marginal rate).

As a transitional measure, the Treasury has been asked to consider allowing people who have paid 45 per cent on a lump sum to claim tax back relative to their normal income tax rate.

What does the government say about this?

The government says it is aware that some pension providers may choose not to offer drawdown, effectively forcing a beneficiary to pay 45 per cent tax on their pension or wait until 2016, when they may get better tax treatment on their lump sum.

It says it will engage with the industry to minimise the risk and to ensure that lump sum payments are taxed at marginal rates from 2016/17.

Why does different tax treatment apply after age 75?

The pension system has for a long time had different tax treatment for those dying before and after the age of 75. The Treasury has not explained why, but according to projections from the Office for National Statistics, fewer than one in five men and women aged 65 in 2014 will be dead by 75. This means only a minority will benefit from passing their pension completely tax free if they die under 75. The majority who are expected to live beyond 75 will see their beneficiaries paying at least marginal tax on any inherited pension fund.

I am in a final salary scheme. Can I take advantage of these rules?

Savers who are building up funds in a private sector final salary pension can ask to transfer their funds into a defined contribution pension drawdown account, where the new tax rules will apply.

But there are restrictions for those in the public sector unfunded pensions, such as nurses and teachers, where transfers are to be banned.

Advisers suggest that anyone considering giving up a final salary pension carefully consider their decision because these pensions carry many benefits, including index-linked rises, spouse’s pensions – and certainty.

However, if you are in a defined benefit scheme, and are in very poor health, then transferring your benefits to take advantage of new death tax rules, could mean the entire fund transfers to an heir without tax if you die before 75.

Why has the government done this now?

Most people have bought an annuity at retirement. But big changes to pension rules, starting from April, are expected to see more people move their cash into a pension drawdown account instead of buying an annuity. The government believed the tax rate on death of 55 per cent on money in drawdown was too high and would put people off moving savings into these accounts – or encourage them to spend money too quickly.

How do I nominate my beneficiaries?

All pension providers should allow you to nominate your beneficiaries, when you start the pension or at any subsequent time. However, the nomination is not usually legally binding. You should contact your pension provider to ensure your nomination reflects your wishes.

How do these changes fit in with the other pension changes announced?

The death tax changes are due to come into effect in April next year, at the same time as big reforms which will allow pension savers new freedom to cash in their pension. The parliamentary timetable for implementing all the measures is very tight.

For the changes: Ros Altmann

Ros Altmann, director-general of Saga Group, speaks during the "Insurance and Government: Today, Tomorrow and Beyond" summit in London, U.K., on Tuesday, Feb. 12, 2013. The Financial Stability Board, an international panel of regulators that set global standards, plans to determine which insurers are too big to fail in April before stricter supervision is enacted. Photographer: Simon Dawson/Bloomberg *** Local Caption *** Ros Altmann
Ros Altmann © Bloomberg

The recent policy changes will make pensions work better for everyone because they spread advantages previously enjoyed by the wealthiest to those with more modest funds.

Unless you have substantial savings, the current regime is inflexible, forcing savers to buy annuities or income drawdown products. Any lump sums left when someone died faced a draconian 55 per cent tax penalty unless you were wealthy enough to leave your pension fund untouched and unlucky enough to die before 75.

The new rules allow you to spend your pension fund as you wish from age 55, without having to buy specific products, and the death tax is being abolished. Whatever the size of your savings, you can benefit from the flexibility and choice previously enjoyed by top earners and pass on unspent pensions to loved ones tax-free.

Pensions have been transformed from a “locked box” with restrictions on withdrawals, into long-term savings to suit individuals. Tax-free inheritance introduces a meaningful incentive to keep money in your pension fund, rather than spending it, whereas the 55 per cent death tax encouraged earlier depletion. This should provide money in later life if you need it and can then help future generations if unused.

The pension reforms make the framework more coherent. A flat-rate state pension, coupled with the Budget freedoms, ends means-testing penalties on private pensions, trusting long-term savers to make sensible decisions. This should boost auto-enrolment and encourage more people to save. Change on this scale is disruptive, and it is vital that people are helped to make sensible choices, but it is nevertheless a vast improvement.

Ros Altmann is an economist and independent pensions expert

Against the changes: Mick McAteer

Mick McAteer
Mick McAteer

The chancellor certainly knows how to spring a surprise. The shock announcement in the Budget scrapping compulsory annuitisation was greeted almost euphorically by much of the industry and the media. This week saw him produce another rabbit: the scrapping of the so-called ‘death tax’ on inherited pensions.

The reforms are sold as liberating pensions. But will more consumers face a secure comfortable retirement as a result? In our view, the answer is no. The reforms could set back the progress made and expose more consumers to unacceptable risks.

Scrapping the death tax will benefit only a few wealthy households. The reforms to annuities are far more worrying. Reform was needed, but the free-for-all exposes consumers to much greater longevity risk (where people outlive their pension pot). Consumers could also face much higher costs for advice, distribution and product developm t, extracting more value from already-limited pension pots. The better-off and plain lucky might do well, but the real winners will be the pensions industry.

And the reforms do little to help households who cannot afford to save much for retirement, such as the low paid and millions of self-employed. They face a brutal squeeze on earnings and do not benefit from an employer’s pension contribution. Yet the UK spends tens of billions of pounds every year on pension tax relief which mostly benefits the better-off and is not efficient at encouraging new retirement saving. Much of what is saved is consumed by an underperforming, high-charging, inefficient pensions industry. We should cap pension tax relief and use the savings to top-up pension contributions of the low paid and self-employed into qualifying pension schemes.

Mick McAteer is founder of the Financial Inclusion Centre

Pensions: a new IHT planning tool?

The chancellor’s proposal for unused pension funds to be passed tax-free to their heirs on death could allow pensions to serve a new purpose: inheritance planning, writes Adam Palin.

With the removal of the 55 per cent tax rate that is currently payable on money remaining in a pension pot, beneficiaries will be either taxed at their marginal income tax rate – if the deceased is 75 or older – or not at all if they died under 75.

For estates that would be subject to larger inheritance tax liabilities – payable at a rate of 40 per cent on assets above a threshold of £325,000 – it could be particularly attractive to allocate non-property assets to a pension, up to the lifetime allowance of £1.25m.

“The plans clearly provide an incentive to use pension schemes for inheritance planning,” said Frank Haskew, head of tax faculty at ICAEW, the UK accountancy body.

They also mark a small but subtle shift in emphasis. Inheritance tax liabilities are calculated based on the value of the deceased’s estate; the circumstances of the beneficiaries are not considered. But under the proposed rules for inheriting pension pots, income drawn would be taxed at the marginal rate of the beneficiary.

The Mirrlees review of taxation by the Institute for Fiscal Studies recommended switching to a system based on the financial position recipienteipient rather than the benefactor, noting that Ireland has used such a system since 1976.

The unanswered questions

The clarification of the tax treatment of pension funds at death completes another important part of the reforms that George Osborne announced in March, writes Jonathan Eley.

But there is still uncertainty over the guidance guarantee – the chancellor’s promise of free face-to-face discussion of an individual’s retirement options. Beyond the 2015 general election, there is also uncertainty over other elements of pensions policy.

George Osborne at this week's Conservative party conference

Some think there will be changes to pensions tax relief. Currently, contributions attract tax relief at the individual’s highest marginal tax rate, resulting in some £34.8bn of foregone tax revenue each year. Critics say much of this relief goes to the well-off, and Labour has already said it will reduce tax relief for those earning more than £150,000. The Liberal Democrats also favour a reduction.

Cutting the lifetime allowance, from £1.25m to £1m, is also a Lib Dem aspiration. The lifetime allowance is the maximum that an individual can amass and still claim tax relief.

Savers in private sector final salary schemes could in theory switch to defined contribution schemes from next April to take advantage of the lighter tax treatment and greater flexibility. Some wonder if, in time, those in unfunded public sector pension schemes may demand the same – as things stand, they are banned from switching into DC schemes.

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Letter in response to this article:

Huge tax loss is likely from new rules on pension pots / From John Ralfe

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