Since April 2015, the rules around death benefits for defined contribution (DC) schemes have changed providing more flexibility and greater tax planning opportunities on death.
So what are the options, opportunities and issues to be aware of around pensions and legacy planning?
Death benefits – the options
Death benefits are either subject to income tax at marginal rates on the beneficiary or tax free. The only differentiator for determining which will apply is the age at which the member dies. So where death of the member occurs prior to age 75, any benefits left to the beneficiary will be tax-free. However, where the member dies at age 75 or any time after, the benefits will be subject to income tax at the beneficiary’s marginal rates of income tax. Diagram 1 below illustrates the position.
Death benefits may also be subject to a lifetime allowance charge on the death of the member. Where funds are uncrystallised and the member dies before the age of 75 and any benefit is paid within the 2-year period, any amount over the lifetime allowance will be subject to a tax charge. This is the timeframe the trustees of the pension scheme have to pay out any death benefit, from when the member died, or when they could reasonably have expected to know of the member’s death.
If benefits have been crystallised prior to members’ death then no lifetime allowance test applies, regardless of when the original member died.
Who can be a beneficiary?
The ability to leave pension death benefits to non - dependants opens up estate planning opportunities. In addition to the lump sum payment, a beneficiary’s flexi-access drawdown can go to anyone the member nominates (in most cases this will be at the trustees or scheme administrator’s discretion). There are two new classes of beneficiary, nominees and successors.
A nominee is anyone other than a spouse or other dependant of the member and a successor is the nominee or dependants’ choice of beneficiary to leave any remaining funds to on their subsequent death.
So how does a beneficiary’s drawdown work in practice?
Diagram 2 below illustrates this in terms of who can receive benefits and how benefits could be taxed depending on the age at death of the last holder of the plan.
A beneficiary’s flexi-access drawdown offers more flexibility, in terms of who can receive benefits than was previously available prior to the pension freedoms and in terms of unrestricted income and potential tax efficiency.
So is there still a case for using a spousal bypass trust?
Well that depends! Where the member wants to retain greater control over how death benefits are used and for whom, setting up a bypass trust may be a more suitable option. Using a bypass trust allows the member to choose the trustees and the trust can pass benefits to a number of beneficiaries on a discretionary basis retaining IHT tax efficiency. The trust can loan money to the beneficiaries which does not form part of their estate when they die.
From a tax perspective any lump sum paid into the trust where the pension member dies before age 75, would be paid tax free but where the member dies on or after their 75th birthday then it would be subject to 45% tax prior to being paid into the trust. If this income is then distributed to a beneficiary, who is not an additional rate taxpayer, they can claim a tax credit for the difference between their marginal rate and that paid by the trust.
Any monies within the trust will, in the case of a discretionary trust, be subject to periodic and exit charges. How the periodic charges are calculated, in terms of the start date that is used, will depend on the type of pension (for example trust based or contract based) the lump sum benefits originated from. This can be further complicated where plans have received transfers-in prior to death or more than one type of pension arrangement’s lump sum death benefit is being paid into the same bypass trust.
Estate planning ideas
Making pension contributions on behalf of other family members may also be a useful way to move money out of an individual’s estate while at the same time building up retirement benefit for other family members. Although the donor /contributor will not benefit from the tax relief, the family member will get tax relief on the contribution, paid on their behalf, at their highest rates of marginal tax. It is important to note that all the normal annual allowance restrictions apply to the receiver, including any relief being limited to 100% of their relevant earnings. Even if their family member has no relevant earnings, they can still make a gross contribution up to £3,600 each year.
As a result of pension freedom legislation, there is now much more flexibility on the distribution of pension death benefits which brings more opportunities in terms of succession planning.