Pension death benefits 2

Summary

This is the second of two bulletins looking at the changes to the tax treatment of pension death benefits from 6 April 2015.

This bulletin provides a brief summary of the changes in the new legislation as they affect money purchase benefits, and we then look at a planning opportunity to meet income needs in retirement whilst also maximising potential death benefits for future generations.

Facts and analysis

A brief summary of the changes is as follows.  Please note that a more detailed explanation of the changes can be found on the bulletin Pension Death Benefits 1.

Member Dies Prior to Age 75 with crystallised or uncrystallised fund

Benefit Options

Taxation

Benefit Crystallisation Event (BCE)

Lump sum

Free of tax if paid within 2 years

BCE 7 if uncrystallised

No if crystallised

Marginal rate of income tax if paid to an individual on or after 6 April 2016 outside the 2 year window

No

Flexi Access

Drawdown

Free of tax if designated within 2 years

BCE 5C if uncrystallised

No if crystallised

Income tax if designated outside the 2 year window

No

Annuity

Free of tax if entitled to the annuity within 2 years

BCE 5D if uncrystallised

No if crystallised

Income tax if entitled to the annuity outside the 2 year window

No

Member

Member Dies Age 75 or over with crystallised or uncrystallised fund

Benefit Options

Taxation

Benefit Crystallisation Event (BCE)

Lump sum

Marginal rate of income tax if paid to an individual on or after 6 April 2016

No

Flexi Access

Drawdown

Income tax on the recipient

No

Annuity

Income tax on the recipient

No

Planning Opportunity

The new rules provide the opportunity for generational planning.  On the death of a member the pension fund can be passed on as a dependant/nominee flexi-access drawdown.  On the death of the dependant/nominee the flexi-access drawdown can then be passed on to a successor.  There is no limit to the number of times the flexi-access drawdown can be passed on, and this can continue until a successor opts for a lump sum or annuity instead of a flexi-access drawdown or the funds are extinguished.

Example

Mr Smith has funded his SIPP over many years and also has a deferred defined benefits scheme payable from age 65.  He is looking at his options to provide income in his retirement on 1 October 2017 at age 65.

The value of his benefits are as follows –

Defined benefits scheme - £ 15,000 per annum, increasing by RPI

State Pension - £ 7,000 per annum

SIPP - £ 500,000

Mr Smith and his wife (also age 65) are both in very good heath, and they have 2 grown up sons.  Mr Smith wants an income of around £30,000 per annum with the flexibility to access lump sums as required.  On his death he wants to make sure that his wife has sufficient income to live on and the remainder should go to their two sons in equal shares.

After discussing his income and lump sum requirements with his adviser he has decided to –

  • Take the scheme pension from his defined benefits scheme to provide a guaranteed income for the rest of his life to top up the State Pension.  This means that Mr Smith’s fixed expenses in retirement are met.
  • Although a transfer of the defined benefits scheme was considered so that they could flexibly access benefits, Mr and Mrs Smith are both in good health and they felt that the guaranteed increasing income payable for life was a more valuable benefit than flexibility of access.
  • An annuity has been discounted because the defined benefits scheme provides the minimum income that they require and they want to make use of the flexibility available in terms of taking lump sums/income from the SIPP.
  • Access the SIPP funds via flexi access drawdown taking a mix of tax free cash and taxable income as and when required whilst ensuring that the taxable income remains within the basic rate tax band.

Mr Smith dies at age 74 when his SIPP is valued at £400,000 and the DB pension is £19,000 per annum.  Mrs Smith has a State Pension in her own name of £8,500.  She is still in reasonable health, and with the defined benefits pension reducing to half she needs to replace some of this income.

The options if all of the pension fund is left to Mrs Smith are:

  • Tax free lump sum
    • Any remaining fund on her death will be part of her estate for IHT purposes and potentially subject to IHT at 40%
  • The investment will be subject to income and capital gains tax unless in something like an ISA wrapper
  • Dependant’s flexi access drawdown
    • Fund remains in a tax free investment
    • Any income/lump sums she draws will be tax free
    • If she dies after reaching age 75 and with remaining funds, they will become taxable on the recipients (eg a flexi access drawdown for her sons)
    • Mrs Smith should complete a nomination form to make clear who she wishes to pass any remaining fund to on her death
  • Dependant’s annuity
    • The annuity payments will be made for the remainder of her life free of tax
    • Her sons will not receive any death benefits as the income will cease on her death
    • If she does not spend all of the annuity payments they will form part of her estate on death and potentially subject to IHT at 40%

All of the options will serve the objective of ensuring that Mrs Smith has sufficient income/lump sums for her lifetime.  What is less likely is that they will enable the most tax efficient method of passing on any remaining funds to her two sons. 

An alternative option would be –

  1. Calculate the income that Mrs Smith is going to require for her lifetime, and from this the capital amount required.  For example, let’s say that she is going to require a net income of £23,000 per annum plus a lump sum of £50,000.  She is going to receive £9,500 per annum from the defined benefits scheme (50% spouse’s pension), plus a State Pension of £8.500 which leaves a shortfall of £5,000 per annum.  As Mr Smith died prior to age 75, any income from a dependant flexi access drawdown will be available free of tax.  If we assume a conservative fund growth rate of 2% pa, and a life expectancy of 26 years (age 100), the capital value required for the income would be approximately £106,000 plus £50,000 lump sum.

  2. Mr Smith should therefore have completed a nomination for Mrs Smith to receive £156,000 from his SIPP and this will meet her income and lump sum requirements. On her subsequent death she can nominate her sons to receive any remaining fund, although this will be taxable at their marginal rate if she dies age 75 or later.

  3. Mr Smith should complete a nomination requesting that the remaining fund should be split equally between his two sons.  The sons can elect for a nominee drawdown, and this means that the fund remains invested tax efficiently, any income/lump sum payments will be free of tax for their lifetime and when they die any remaining fund will not form part of their estate for IHT  

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 income tax during lifetime and to maximise death benefits.

In order to maximise the tax savings on death it is essential that each member completes a nomination form, and that they keep this up to date.  In addition to a check on this as part of the normal review process there are events in a client’s life that will trigger a review of the nomination form including –

  • Change in health of the member or their spouse
  • Marriage/divorce
  • Nearing age 75
  • Any change in circumstances

A clear understanding of the taxation of death benefits is important to minimise tax both now and for future generations.

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 2018.  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.