Who Gets My Pension When I Die ?

I think we can all agree that, despite the complexity of pension rules, when you die, you would like to ensure that your pension is passed on to your beneficiaries in the most tax-efficient way.

Prior to 2015, pension rules dictated that pension payments could only be made to your dependants, meaning your spouse or common law partner and children aged 23 and under, when you die. 

The introduction of “pension freedom” in April 2015 changed this. If you have a defined contribution pension, such as a personal pension, you can nominate whoever you wish to benefit from your pension. Not only that, if you die before the age of 75, any pension payments are potentially tax-free.

To provide a cascade of wealth through the generations, you need to ensure that your pension performance is optimised AND that you review how you are passing your pension on after your death. Reviewing your chosen nominations and optimising your pension performance is of particular urgency if you are approaching 75.

To provide your nominees with inherited beneficiary drawdown, they must be named on your nomination form. If death occurs before 75, the pension can be held in the nominees’ names and they can claim the benefits of beneficiary drawdown tax-free. They could also keep the capital invested in a tax-free environment, which would work like a large ISA.

If death of the original pension holder occurs after 75 years, the same inherited beneficiary drawdown rights apply, except that any pension payments are taxed at the recipient’s marginal tax rate, when they accept payment.

CAN YOU PROVIDE SIMILAR BENEFITS WITH AN ASSET PRESERVATION TRUST?

Most pensions are in trust but some practitioners recommend assigning any pensions to a separate Asset Preservation Trust, which would be under the control of your family, as trustees. 

The key differences are:

Death before 75 – growth or income on the trust funds are subject to CGT and income tax: some people suggest that it may be possible to mitigate this tax by investing in non-income producing assets, such as an offshore bond, but the tax is not mitigated, merely deferred.

Death After 75 – having pension benefits paid to a separate trust means that the lump sum will be taxed at 45% up front. Although, when payments are made from the bypass trust, beneficiaries can normally reclaim any excess tax paid on the lump sum. They effectively get a tax credit on the difference between their marginal rate of tax and the penal 45% tax taken up front.

However, the 45% tax charge is taken immediately so the growth is lost on 45% while the funds are in the trust. The loss of growth and income for a pension fund worth £1M over ten years (assuming a net return after charges of 8%) would be £521,516.

NO BENEFIT FROM TAX RE-SET

It’s also important to note that the tax treatment of an inherited drawdown pot is reset and can change each time the pot is passed on. A pension passed to a nominee that is taxed at his or her marginal rate could be passed to a successor tax-free (on death of the nominee before age 75).

This doesn’t apply to Asset Protection Trusts, where the tax treatment is fixed when the original lump sum is paid from the pension. Plus, the usual IHT periodic and exit charges apply to Asset Protection Trust’s assets.

ASSET PRESERVATION TRUSTS

Asset Preservation Trusts still have an important role to play for some clients and shouldn’t be discounted just because, at first glance, they may look complex or less tax efficient.

If the client wants more control over who gets what and when, that’s where an Asset Preservation Trust might deliver an edge that’s worth the extra complexity and a bit more tax.

We recommend setting up a separate Asset Preservation Trust for those clients seeking additional peace of mind, particularly if circumstances are complicated. For example, a client who has remarried and has children from a previous marriage may prefer to pass his pension to his own children, if his wife has a substantial pension of her own, or vice versa.

It is also quite common to have a beneficiary who is vulnerable and unable to manage their own affairs, or is simply hopeless at handling money. These are the sort of circumstances where an Asset Preservation Trust can really help. 

Trustees can be appointed who know the family and are fully aware of the circumstances and are therefore able to assist on an ongoing basis. The trustees should obtain advice on how to invest the pension funds that they are responsible for by drawing up an Investment Policy Statement and appointing an Independent Financial Adviser (Trustee Act 2000).

No one knows for sure what life has in store for them and their future, so having an Asset Protection Trust with your own trustees is a very useful safeguard, should the need arise. An Asset Preservation Trust can be set up as part of the nominations you make alongside your other requests.

DEFINED BENEFIT or FINAL SALARY SCHEMES?

We have confined our advice in the past to defined contribution schemes but many clients are members of defined benefit schemes, typically providing Death in Service benefits of two to four times  their salary. 

If you were to die in service, the trustees would pay out as per your expressed wishes, depending on your salary, which could be quite a large pay-out. The monies will form part of your survivor’s estate and any increase in the size of the estate may give rise to additional inheritance tax. 

If your surviving spouse remarried and then pre-deceased their new spouse, who would benefit from the estate?

If you have a Death in Service policy, the existing trustees will normally allow the benefit to be assigned to an Asset Protection Trust. You would be able to control who the potential beneficiaries are, which is a much more satisfactory arrangement. This option will allow more control and save (potentially) a great deal of tax.

An Asset Preservation Trust can be established and is set up to hold lump sum death benefits from a pension scheme. It enables the death benefits to be held in trust for the deceased member’s spouse, civil partner or other beneficiaries, without forming part of the beneficiaries’ estates.

The trustees can pay out capital and income to the beneficiaries or, if the trust provisions allow, grant them loans which will normally be a debt on their estate for IHT.

As the trust is subject to the relevant property regime, it will be subject to the 10 yearly periodic charges and proportionate exit charges on capital leaving the trust. The timing and calculation of any charges largely depend on the structure of the pension scheme(s) involved.

The payment of lump sum death benefits into an Asset Preservation Trust are tax-free where the scheme member dies before age 75 and benefits are within the lifetime allowance. Where the scheme member dies at 75 or older, the death benefits will be subject to a 45% special lump sum tax charge.

However, when an individual beneficiary receives a payment from the trust from funds that have been subject to the 45% special lump sum tax charge, the individual will receive a 45% tax credit.  The intention of the tax credit is to put the individual in the same position as if they had received the payment directly from the pension scheme. This means that any individual whose marginal rate of tax is less than 45% can claim a tax refund.

THE USE OF ASSET PRESERVATION TRUSTS AND NOMINATION FORMS FOR DEATH BENEFITS IN THE PENSION FREEDOM ENVIRONMENT

Perhaps the first thing to say is that the term ‘asset preservation trust’ simply means setting up a discretionary trust during lifetime, usually with a nominal amount of around £10. On the nomination form, the member indicates their wish that their death benefits be paid to the trust on their death (which isn’t binding on the trustees/provider). The death benefits are therefore ‘bypassing’ the surviving spouse’s estate although the spouse normally retains access to the funds. A bypass trust isn’t exclusive to pension death benefits. 

The main reason (quoted pre-6th April 2015) for using this type of trust was to ensure that the deceased’s beneficiaries had access to the pension death benefits without the beneficiaries’ own estates being increased for inheritance tax (IHT) purposes. 

Since 6th April 2015, it has been possible for pension death benefits to be left in the pension wrapper so the same end result can be achieved without the need for an Asset Preservation Trust (of course, it may not be possible for all pension funds to access inherited drawdown).

In the table below, we have summarised some of the main pros and cons between having pension funds paid to a trust, into the nominee’s flexi-access drawdown account or direct to a beneficiary.

Asset Preservation TrustPaid as lump sum direct to beneficiaryPaid into dependant’s/nominee’s flexi-access drawdown
Protected from assessment in relation to means tested benefits and long-term care funding?YesNoNo
Greater protection if beneficiary dies, becomes bankrupt or divorces?YesNoNo
Payment subject to pension scheme trustees’ discretion?YesYesYes
Member can choose own trustees?Yes. The original member will have provided instructions for the trustees (not later beneficiaries).n/aNo. Each subsequent beneficiary will guide the trustees regarding who their own beneficiaries should be.
Facility to make loans that, if not repaid, will reduce their estate on death?YesNoNo
Payment tax free on death before 75?YesYesYes

NB: If funds pass through the generations the tax rate could alter based on age at death of last beneficiary.

Rate of tax payable on death after 75?45% (a payment made to a beneficiary then comes with a 45% tax credit that can be offset so they end up paying tax at their own rate)Beneficiary’s tax rate(s)Beneficiary’s tax rate(s) 

NB: If funds pass through the generations the tax rate could alter based on age at death of last beneficiary.

Potential for periodic charges? 
YesNoNo
Ongoing taxation of the funds (income and capital gains)?
Trust rates (20% on gains above exempt amount and 45% on income above £1,000 (38.1% for dividends). Investment choice will determine outcome. Investment bonds often used for tax efficiency.Depends on recipients’ personal tax rate(s) and what the fund is used for/invested in.Tax free growth and income within the fund.
Expensive?
Not particularly but all bespoke trusts should be regularly reviewed.

This is advisable to ensure the planning fits in with the your wider objectives and IHT planning requirements.

NoDepends on the product.

Further comment

The trust above is not referring to the scenario where a contract-based pension, such as a section 32 or retirement annuity (and some PPPs/SIPPs), have the death benefits assigned into a specific trust during lifetime (sometimes referred to as ‘a carve-out trust’). In that situation, the trust is irrevocable, although the trust can effectively be ended by the pension being transferred. A nomination in favour of a trust can normally be changed at any time simply by completing a new nomination form. 

On death after 75, if funds are paid to a trust, there would be an upfront 45% tax charge so only 55% of the funds would move into the trust. When funds are paid out to a beneficiary, they receive a tax credit for the 45% tax paid and this can be offset against their own tax bill for the tax year of receipt. However, a payment to a beneficiary may not, in some cases, be made for several years, leaving only 55% of the pension fund to grow within the trust. 

Contrast this position with 100% of the funds moving into flexi-access drawdown and the beneficiaries just paying tax at their own rates when any income is withdrawn from the fund. 

The advantages of the trust would need to outweigh the disadvantage of the 45% upfront tax rate, even if it can be reclaimed at a later date (in most cases, beneficiaries would pay tax at less than 45%, particularly if the funds are shared between several of them). 

However, bearing in mind that the tax position of a dependant’s or nominee’s flexi-access drawdown fund is taxed on any subsequent generations of beneficiaries, depending on the age at death of the last beneficiary, a tax-free income position could become taxable for a future generation. If all funds are placed in trust, tax-free on death of the member aged under 75, this situation can’t arise and nor can future changes in pension legislation affect this. 

If paid to a trust, whilst there could be an IHT liability at every 10-year anniversary of the trust, this would be at a maximum rate of 6% and frequently much less. Payments out of the trust to a beneficiary could give rise to an exit charge based on the rate of tax paid (or deemed to be paid) at the last 10-year anniversary or when the trust was established. This needs to be considered against the risk of a marginal rate income tax charge that could be payable if the funds were left in the pension fund and then paid out after the death of a beneficiary dying aged 75 or over.

It is important to bear in mind that different providers and products have their own structure and rules on which death benefit and trust options are available. There are also wide variations between nomination forms, with some including an option for the member to make a binding nomination (with possible IHT consequences). It is important to take extreme care when completing nomination forms to ensure that the correct boxes are ticked and the right information added, to avoid any unintended consequences later.

PERIODIC CHARGE UPDATE FOR PENSION-LINKED TRUSTS

Where pension death benefits are paid to a trust, many people assume that the first 10-year anniversary will be 10 years after the death benefits were paid into the trust (or 10 years from when that trust was set up). However, HMRC take the view that where the death benefits come from a trust-based pension scheme, the commencement date of the trust is the date that the individual joined the pension scheme. This aspect isn’t new. 

It has been thought until now that if the pension arrangement is governed by a deed poll rather than a trust, this is classed as a ‘contract-based’ arrangement, with any bypass trust only starting from the date  that the trust was actually established. However, HMRC has apparently confirmed its current position that if, under the ‘contract-based’ scheme, the scheme administrator has discretion over payment of death benefits to anybody in the discretionary class, those funds are classed as being held in a settlement, i.e. they are treated the same as if the pension was trust-based. 

This means that, if the scheme administrator pays death benefits to a trust, the death benefits will be treated as being held in trust from the date the member joined the pension scheme (or, if there have been any earlier transfers from trust-based schemes, or schemes set up by deed poll where the administrator has discretionary powers, the date of joining that earlier arrangement will be the trust start date).

Where the pension arrangement is written subject to an integrated trust – one to which the scheme administrator must pay lump sum death benefits – and most often seen with contract-based plans like retirement annuities and section 32 plans, then the commencement date of the trust is either: 

  • The start date of the pension plan if the plan was placed in trust from outset (or if the funds have been transferred from a trust-based pension plan, the start date of that plan)
  • Or, if the plan isn’t placed under trust from outset but the death benefits were payable at the scheme administrator’s discretion, HMRC will regard the death benefits as being in trust from outset. Therefore if an integrated trust is implemented later, the trust start date will still be treated as the start date of the pension plan.

Depending on the particular circumstances and the amount held within the trust, periodic charges may not be relevant but it’s important to be aware that once death benefits have been paid into the trust, it isn’t safe to assume that there will be no periodic charge assessment until the next 10-year anniversary from when the trust was set up.

As an example, if the death benefits came from a trust-based pension plan that started in January 2010, which had a previous transfer from a trust-based pension that started in February 1999, and the death benefits were paid to a bypass trust in October 2015, the first periodic charge assessment point would be February 2019 (as the start date of the trust is classed as February 1999).

NEW FLEXIBILITIES ON PENSION DEATH BENEFITS

With regard to the new pension flexibilities for death benefits – especially the facility to pass funds down through the generations via flexi-access drawdown, and the possibility of paying death benefits to a far wider range of beneficiaries – it is important to bear in mind that it may be impossible to make use of these options if the pension plan or scheme doesn’t offer them. 

It has never been more important to check whether your pension arrangements can be used in the way that you would like on your death as it may be too late to do anything about it once you have passed away.  

If your clients have pensions that can’t facilitate the new freedoms, for example, older pension plans that don’t give the option of dependant’s/nominee’s drawdown (inherited drawdown), the beneficiaries could find that the only option available to them is annuity purchase or to take a lump sum. This is probably not the most tax-efficient method of extraction because lump sums are currently taxed at the recipient’s own tax rate(s) but the lump sum doesn’t have to be particularly large for at least some of it to be taxed at 40%.

It has never been more important to have a modern, flexible pension that will facilitate the full range of death benefit options. It is also critical to keep death benefit nominations and nomination forms up-to-date as part of regular client reviews.

ENSURING DEATH BENEFITS CAN BE PAID IN THE DESIRED FORMAT TO THE RIGHT BENEFICIARIES

Points to consider:

  • What would you like to happen to any remaining pension fund on your death?
  • Would you like your beneficiaries to have the option of the tax efficiency and flexibility of inherited drawdown?
  • Is a secure fixed income from a survivor’s annuity more appealing?
  • Would a lump sum death benefit be better directed to a bypass trust where the member’s chosen trustees can have the control over who benefits and when (which could include making loans)?
  • Can your existing pension scheme facilitate your preferences? Not all pensions allow lump sum payments to be made to a bypass trust and not all pensions offer inherited drawdown.
  • Nomination/expression of wish form issues (referred to as ‘nomination forms’ below):
    Even where the pension arrangement offers all the new freedoms, it’s crucial that nomination forms are kept up-to-date and fully reflect the client’s wishes.
    A death benefit nomination helps to guide the scheme trustees/administrators when exercising their discretion and they will rely on the most recent nomination form they have received. Nomination forms can normally be changed at any time.
  • The new rules around who can inherit make it even more important that nomination forms are correctly completed. If the member wants someone other than a dependant to inherit and would like them to have the option of inherited drawdown, the member must name them on the nomination form.
  • The scheme trustees cannot exercise their discretion to offer a non-dependant the inherited drawdown option if there is a surviving dependant, unless the deceased had nominated the non-dependant during their lifetime. This doesn’t apply to payment of a lump sum death benefit – a lump sum can be paid at the trustees’ discretion to a non-dependant even if there is a surviving dependant.
  • Issues can also arise where members have completed a nomination form with instructions that the lump sum death benefit be paid to a trust. Some nominations to a trust can be made binding upon the scheme administrator, in which case the scheme administrator must follow this instruction and has no discretion to pay to anyone else, but this can be revoked by completing a new nomination form.
  • You should take advice to decide if a trust is still the right option. Bear in mind that a lump sum paid to a trust post 75 is taxed at 45% upfront with a corresponding tax credit when paid out to a beneficiary (which they can offset against their own income tax bill).

AND FINALLY

It is important to have a clear picture of your death benefit position and options for each of your pension plans and to make sure you are aware of any restrictions or limitations that apply. 

As described above, dying with an out-of-date nomination might mean that the pension pot can’t be passed to the desired beneficiaries or in the right format. Post 75 death benefits that are forced to be paid out as a lump sum can be far less tax-efficient than a move into inherited drawdown where there is no compulsion to withdraw any income immediately and withdrawals can be taken over time for maximum tax efficiency. 

If you would like a review of your pension arrangements, please click HERE.

Ray L Best

Ray Best is a resilient Financial Planner with a unique approach to investment planning, his work ethic has propelled him from humble beginnings to be voted as a top UK Financial Planner by Vouched For (as published in the Sunday Times). These days he works with families with large investment portfolios or big inheritance tax liabilities, the first step, is to book a Discovery Meeting HERE.

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