Pension death benefits (part one)

Summary

The Taxation of Pensions Act 2014 and Finance Act 2015 introduced substantial changes to the tax treatment of pension death benefits from 6 April 2015.  This seismic change in the rules has created tax planning opportunities for clients.  As we shall see, it is unlikely that anyone will be worse off as a result of the changes and it is simply how much advantage a client can take of the new rules.

This bulletin summarises the changes in the new legislation as they affect money purchase benefits, and we then look at planning opportunities for a client with both pension and ISA savings to maximise the death benefits.

Facts and analysis

Let’s start with an overview of the new rules from 6 April 2015, and we can then go on to consider what some of those changes mean in terms of planning.

Key points –

• The options available depend on what the scheme offers.

• The fundamental options have not changed even if the detail has – when a member dies the main three options are to take the fund as a lump sum, set up a drawdown, or use the fund to purchase an annuity.  A fourth option available to some members will be a scheme pension.

• Whether a fund is crystallised or uncrystallised is no long longer relevant for most purposes.  Even if a fund is crystallised it will still be paid free of tax if the member dies prior to age 75.

• The option of a drawdown pension or an annuity is now open to any beneficiary and is no longer restricted to someone who is a dependant.  A ‘nominee’ is an individual who is nominated by either the member or the scheme administrator and is not a dependant of the member.  A nominee can include non-dependant children, grandchildren and indeed anyone that the member/scheme administrator has nominated.  However, a scheme administrator cannot nominate someone in this wider class where there is a dependant of the member or where the member has already nominated someone.

• If the drawdown option is chosen this will be a dependant’s or nominees’s flexi access drawdown
• If an annuity is chosen this will be a dependant's or nominee's annuity

• The age of the member at death does not impact on the options available to the dependants/nominees, only the tax treatment of the benefits.

• There are two new benefit crystallisation events – BCE 5C and 5D.  Previously where a member died with uncrystallised funds and a dependant’s pension or annuity was paid rather than a lump sum, there was no BCE.  The new BCEs are –
  • “5C. The designation, on or after 6 April 2015 but before the end of the relevant two-year period, of relevant unused uncrystallised funds as available for the payment, to a dependant or nominee of the individual, of (as the case may be) dependants’ flexi-access drawdown pension or nominees’ flexi-access drawdown pension.’
  • ‘5D. A person becoming entitled, on or after 6 April 2015 but before the end of the relevant two-year period, to a dependant's annuity or a nominee's annuity in respect of the individual if -

  (a) the annuity is purchased using (whether or not exclusively) relevant unused uncrystallised funds, and

  (b) the individual died on or after 3 December 2014’

• On the death of the dependant/nominee where the drawdown option was chosen, the same process is repeated.  The dependant/nominee can make a nomination for who they want to receive any remaining pension fund (there is no longer going to be any reference back to see if there are any other dependants of the member except where a charity lump sum is nominated by the dependant/nominee). A ‘successor’ is a dependant of, or an individual nominated by a dependant/nominee/successor of the member or the scheme administrator. The taxation of the successor benefits will be determined by the age of the dependant/nominee/successor at the date of their death.  Hence, you could have a fund which is taxable on the death of the member because they were aged 75 or over, but which subsequently becomes tax free for the successor because the dependant/nominee/successor was under age 75 when they died.

• There is a change to the rules for scheme administrators using their discretion on the payment of death benefits.  Both the member and the scheme administrator can nominate a dependant and/or nominee to receive the death benefits.  The scheme administrator cannot use their discretion to nominate an individual to receive a nominee’s flexi-access drawdown or annuity where either there is a dependant of the member or the member has made a nomination.  For example, if the member has a spouse and a non-dependant daughter and has not made any nomination, the scheme administrator could not nominate the non dependant daughter to receive a nominee’s flexi-access drawdown.  If, however, the member has made a nomination in favour of the daughter the scheme administrator can use their discretion to follow the wishes of the member and make the payment of either a lump sum or nominee’s flexi-access drawdown to his daughter.

• As previously, a nomination to pay a charity lump sum death benefit can only be made by a member, and not by a scheme administrator.  The scheme administrator can also only make a charity lump sum death benefit payment where there are no dependants of the member.  The rules now allow for a charity lump sum death benefit to be paid following the death of a dependant, nominee or successor, in receipt of drawdown although again only where there are no remaining dependants of the member.  The charity can be nominated by the member, or if no member nomination by the dependant, nominee or successor.

• If the member dies prior to age 75, but benefits are not paid within the 2 year window a tax charge will apply.
  • If paid as a lump sum between 6 April 2015 and 5 April 2016 was subject to the special lump sum death benefit charge, which is a charge of 45% deducted by the scheme administrator
  • If paid as a lump sum to an individual on or after 6 April 2016 is treated as the recipient’s pension income and tax is deducted under PAYE
  • If paid as a dependant’s or nominee’s flexi-access drawdown or annuity the payments will be taxed at the marginal rate of income tax.
• The two year window begins with the earlier of the day on which the scheme administrator of the scheme first knew of the member’s death and the day on which the scheme administrator could first reasonably have expected to have known of it.  The end of the two year window depends on how benefits are taken as follows –
  • Lump sum – the date that the lump sum is paid
  • Flexi-access drawdown – the date that benefits are designated to the flexi-access drawdown
  • Annuity – the date that the beneficiary becomes entitled to the annuity

Planning Opportunities

For many years Advisers have employed planning strategies such as phased drawdown to maximise the uncrystallised funds prior to age 75 and minimise the crystallised funds in order to maximise the death benefits.  This no longer applies, and means that tax planning on income withdrawals places more emphasis on income tax planning than on death benefit planning.  That is not to say that death benefit planning is no longer relevant, but simply that the options for taking income will no longer impact on taxation of the death benefits.

The impacts of this go further that just the pension itself.  In the past an effective tax planning strategy was to extract funds out of the pension prior to age 75 because from that age any funds remaining on death would become subject to the recovery charge at 55% if taken as a lump sum.  For many it was therefore more tax efficient to maximise the income taken from the pension fund prior to age 75, and then rely more on other investments post age 75. This position has now changed and purely from a tax perspective it may be better for a client use investments outside of the pension wrapper prior to age 75 (which are potentially subject to inheritance tax (IHT) at 40%) to provide income compared to the taxation of funds within the pension wrapper which on death post age 75 will are taxable at the recipient’s marginal rate of income tax.

For example, Brian has decided to retire at age 70 with a pension fund of £300,000 and ISAs valued at £300,000.  The value of his remaining estate is £700,000.  If Brian uses solely his pension to provide his income in retirement and preserves his ISAs, then on his death any remaining pension fund can be passed on outside of his estate (either tax free or income tax at the marginal rate of tax of the recipient, depending on his age at date of death).  This compares to his ISAs which will be liable to IHT at 40% irrespective of date of death (assuming no spouse/civil partner). 

The figures below are based on Brian taking an income of £30,000 per annum from his ISA, annually in advance and investment returns of 5% per annum.

*Assuming recipient draws income from a drawdown arrangement within the basic rate tax band.  No tax is due until withdrawals are taken and hence the full £443,237 is passed to the recipient.  If paid as a lump sum there would be higher and additional rates of tax paid.

This compares to the figures below based on Brian taking a net income of £30,000 per annum from his pension annually in advance and investment returns of 5% per annum.  It is assumed that income will be taken as tax free cash until extinguished and then taxable income net of basic rate tax.

*Assuming recipient draws income from a drawdown arrangement within the basic rate tax band.  No tax is due until withdrawals are taken and hence the full £94,943 is passed to the recipient.  If paid as a lump sum there would be higher and potentially additional rates of tax paid.

Please note that the example above assumes that Brian is single.  If he was married/in a civil partnership at the time of his death there would be no IHT if his ISAs are inherited by his spouse, but they would be part of her/his estate on their subsequent death and assessable to IHT at that point.

Next steps

The changes to the taxation of death benefits whilst unexpected are an opportunity for many to save considerable amounts of income tax and IHT. The new rules mean that a review of how income and tax free cash is being taken from a drawdown arrangement is important to ensure that is remains the most tax efficient strategy to reduce tax on income drawn and to maximise death benefits.

Important information

This information has not been approved for use with customers and is based on Aviva’s interpretation of current law and legislation, and our understanding of HM Revenue & Customs (HMRC) practice as at 6 April 2021.  It is provided for general information purposes only and should not be relied upon in place of legal or other professional advice.  Both the law and HMRC practice will change from time to time and our interpretation may be subject to challenge by HMRC or other regulatory body. Aviva cannot act as legal adviser for you or your clients.  You should always seek appropriate legal or other professional advice.