Over the years, that has
changed: and especially since the so-called A-Day (6th April 2006,
the date on which “pensions simplification” came into effect) pensions have
become regarded as a fairly flexible form of investment.
There are two circumstances
in which a pension fund will pay out a lump sum on the member’s death:
1. Death in service: this is often a fixed sum
(sometimes, in occupational pension schemes, related to the member’s salary)
and usually in addition includes a return of the member’s contributions plus growth.
2. The balance of the fund after retirement: unless and
until the fund is annuitised (explained below) then the balance of the fund,
less any income already “drawn-down” and less any tax payable on the death, is
paid out as a lump sum.
A pension which is
annuitised in the traditional way (i.e. the fund is cashed-in to buy an annuity
which pays a monthly income to the member (and widow(er), if relevant) until
death) ceases to be of interest to us from an IHT-planning viewpoint. That is
because there will be nothing left at the death to tax-plan with. The person
who wins most from annuitising his or her pension is the member who lives for
many more years than expected and keeps drawing the income. The person who
loses most is the heir of a member who dies very shortly after annuitising: who
gets nothing.
So, where does inheritance
tax come in? The answer is that these lump sums paid out of pension schemes are
IHT free, provided that the pension fund trustees pay out the fund at their
discretion, and not to the member’s estate. (So it is important to check that the
fund is set up in this way, although most are. It is also important to
“nominate” your pension – that is, to tell the scheme’s trustees who to pay the
money to, if the worst happens.)
You may be asking ‘if
there’s no inheritance tax, why did you say “...less any tax payable...” in
item 2 above?’ Good question. The answer is that when a member takes a pension
draw-down (which means that he or she didn’t annuitise the pension fund, but
instead left the fund intact and drew an income from it) he or she suffers income tax at 55% on the balance left in
the fund at death.
So far, you may be thinking,
so good. We’ve had the problem with the income tax but, that aside, everything
seems positive. Certainly there are no IHT problems – on the contrary, it’s all
IHT free. And you would be right. But any tax advantage is also a threat: the
threat that you might fail to take advantage of it. In this case, for example,
what you might have done (in fact, I bet you did!) is to nominate your spouse
as the recipient of your pension lump sums. And gifts to spouses are IHT-free
anyway. So we’re back to the problem, mentioned a before on my blog, of
having used two tax reliefs where one would have done, and of bunching
everything into the estate of the survivor: an estate where it won’t be a pension fund any more, just a wodge
of cash to be taxed at 40% when the second death comes. And especially if it
suffered the 55% tax before the survivor received it, paying a further 40% on
the same money again is just adding insult to injury.
So what do we do?
If you are in drawdown, your widow(er) could just stay in drawdown.
The best answer is that you
put the death benefits into a discretionary trust. (There are two ways of doing
this: you either “nominate” a discretionary trust in your will to be the
recipient, or you actually “settle” your pension schemes onto one or more
trusts in your lifetime. The bigger the pot, the greater the advantage of the
second method.) The reason this works is the same as for the other first-death
discretionary trusts we have mentioned. The survivor has access to the pot if
needed, because the trustees have discretion to provide funds to him or her.
But the pot doesn’t belong to the survivor (it is “not in the survivor’s tax
estate” as we lawyers put it) and therefore is not taxed on his or her death.
