Pensions and the ‘D’ word

David Smith, director, financial planning at Tilney, looks to clear the haze and potentially assist individuals in saving thousands of pounds in tax

Pensions and the ‘D’ word

No one likes to talk about their own or their loved ones’ future demise, but unfortunately death is one of the few certainties in life. Whilst many recognise the importance of Will writing and funeral planning in preparing for the inevitable, there is one issue that is often overlooked: pension death benefits.

This is undoubtedly due to confusion surrounding the issue rather than simple inaction or ignorance; it was recently reported that HMRC sent thousands of tax demands in error to beneficiaries, for an unknown reason. If HMRC can’t get it right, what chance do the rest of us have?

Death benefit

Perhaps the most widely undervalued aspect of pensions is the death benefit. The extent of the tax efficiency however depends upon the age of the deceased. If death occurs before the age of 75, the pension can be paid to the deceased’s beneficiaries as a lump sum or an annuity, completely free of tax. If death occurs after the age of 75, the benefit does become taxable but only at the beneficiaries marginal rate of income tax, in each instance, potentially saving up to 40% in inheritance tax (IHT).

The real benefit however, is the ability for beneficiaries to inherit pensions. In each of the instances I’ve referred to rather than receiving a lump sum or income, they could inherit the pension pot, from which they could draw lump sums or income either tax free or at their marginal rates of income tax. With the latter, drawings can be planned to coincide with favourable tax statuses, to mitigate tax as much as possible. Either way, it would be better than beneficiaries paying 40% IHT on the whole amount.

What’s more, these pensions can be passed down through the generations, continually remaining outside of the estate of the deceased and each time the holder of the pension dies, it is their age which determines the tax regime applied. For example, a husband could die age 76, pass a sum of £100,000 to his wife and the pension pot would be taxable on everything she draws. If she were to die soon after aged 74 with the pot untouched, it could pass to their daughter completely free of tax.

The same situation involving lump sums being inherited would have seen the mother pay up to 45% income tax upon receipt of the benefit and subsequently the daughter pay a further 40% in IHT, resulting in total tax of up to £67,000. To avoid such punitive charges, it is imperative that the individual is in the right type of pension – before death occurs. These benefits are not automatic and adequate planning is required before the worst comes to fruition.

Trusts

Sometimes too, individuals may have put in place plans that in the past would have been in their best interest but now simply act to compound the problem, such as looking to pass death benefits to a Trust. Whilst this may mitigate the initial charge to IHT, the Trust will be subject to a number of other tax charges. If they simply had the right plan and an expression of wish, the job of mitigating IHT could be done without all the fuss.

What many people do not understand, is that a pension plan is not owned by the individual and a Will has little bearing on the destination let alone the power to ensure the tax efficiency of the death benefits. It is an absolute necessity therefore, that the individual provides the pension scheme with an expression of wish to ensure death benefits reach individuals’ intended beneficiaries.

Pension plans are not simply a means of an income in retirement, but also a valuable estate planning tool. Those looking to ensure their beneficiaries get the most out of their inheritances should move their pension plans to one allowing the plan to be inherited and above all, ensure their expression of wish is up to date otherwise the sum may never reach those intended. The use of Trusts in the past and the seemingly ever continual change to pension legislation would also suggest that you should continually review your arrangements.

Apart from our homes, pension pots tend to be our largest asset when approaching or in retirement and, with many thousands of pounds at stake, it’s time to clear up the confusion and start planning for our loved ones.

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