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 dependents, 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 an 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 the 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.
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 a dependent’s or nominee’s drawdown (inherited drawdown), the beneficiaries could find that the only option available to them is an 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 funds upon your death?
- Would you like your beneficiaries to have the option of the tax efficiency and flexibility of an inherited drawdown?
- Would you prefer a secure fixed income from a survivor’s annuity?
- Would a lump-sum death benefit be better directed to a bypass trust where the member’s chosen trustees can have 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 drawdowns.
- 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 guide the scheme trustees and 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 dependent to inherit and would like them to have the option of inherited drawdown, the member must name them on the nomination form.
- The trustees of the scheme cannot use their discretion to give a non-dependent person the inherited drawdown option if there is still a dependent person alive unless the person who died chose the non-dependent person during their lifetime. This doesn’t apply to the 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 dependent.
- 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 after 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 an 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.
