It is important to clarify what happens to pension funds when clients pass away. We recently had a query from clients who each have significant pension funds (which are in drawdown) and they wanted to know what would now happen with the funds after they had both departed.
When writing your will this deals with the assets that fall INSIDE your estate after you have passed on, however a pension does not form part of your estate therefore is dealt with separately (although in your will you can back this up in a separate clause if you wish, so there is no ambiguity).
Previously it was only possible to nominate your spouse to receive pension benefits after death (which were transferred into a pension in their own name) but now this has changed. Pension benefits can be nominated for any beneficiary, so you can choose to whom the payment(s) are made. The proportion of the fund you nominate for each beneficiary will then be placed into a pension in their own name. This pension can be paid to them before they reach retirement age as well, and it won’t form part of their own estate so it can be passed on again!
This is done by completing a nomination form with your SIPP provider. These forms are used as a guideline for the Pension Trustees to follow when it comes to payment. If there is no nomination form in place then the trustees of the pension will look to the will, which may mean a different course of action than the one you intended.
Completing a nomination form for specific beneficiaries (they must be named, not grouped under types such as child or grandchild and income cannot be paid to a trust) allows for pension funds to be ‘cascaded’ down the generations in line with your wishes, so it is important to review them regularly to make sure they are up to date.
So what else has changed?
Previously the taxation of pension funds was determined by whether the pension fund had been crystallised or not – i.e. was the fund being used to pay drawdown pension to the member? If it was, then it was subject to a 55% tax charge on death (i.e on payment out if the spouse wanted to take it as a cash lump sum) and if it wasn’t in drawdown then it was free of the 55% tax charge providing the pension holder was under 75, if they were over 75 it was still taxed at 55%. Clear as mud?
Now, the age at death of the pension holder is what determines the taxation of the fund when it is passed on, as shown below:
- On death before 75, any pension death benefits (i.e. the fund) can be paid tax free.
- On death after 75, the beneficiary pays tax on any income or lump sum they draw from the fund. So in this case it would depend on the beneficiary’s tax status meaning careful planning on how much income to take each year (plus any other income they get) could minimise the amount of tax to be paid.
- For individuals, the tax treatment is the same if the fund is taken as income or a lump sum – that is, it will be taxed at the beneficiary’s rate of income tax.
There are now 2 ways to pass on benefits to your family through a pension, and these allow you to have varying degrees of control over the funds even after death.
Option 1: Inherited Drawdown
For the first time in pension history, pension wealth can be passed to adult children within the pension wrapper (rather than having to pay it out of the pension which would have been chargeable) and there is no requirement for the beneficiary to wait until they reach 55 to access the funds.
The tax benefits of this option are threefold:
- The fund remains invested in a tax free environment with income and gains tax free from income tax and capital gains tax
- The pension fund also remains outside the beneficiary’s estate for IHT purposes, and doesn’t count towards their own Lifetime Allowance (LTA) so they can carry on funding their own pension. The inherited pension can also remain in the pension wrapper after the beneficiary’s death as they can nominate their own successor.
- The tax on income withdrawals is determined by the deceased’s age on death (as per page1) and subsequently it will be the age at death of the beneficiaries that determines how their successors are taxed, and so on.
a) Where death occurs before age 75 then the pension pot is payable tax free to the beneficiary
b) For deaths after 75 withdrawals will be taxable at the beneficiary’s marginal rate.
Option 2: Bypass Trusts
Traditionally, a popular way of passing on pension wealth tax efficiently has been the use of bypass trusts, whereby the pension death benefit lump sum is paid to a discretionary trust from which family members can benefit.
They are often referred to as ‘spousal bypass’ trusts as one of the key benefits allowed the spouse access, at the trustee’s discretion, but without it forming part of their estate for IHT. Using ‘spouse’ is a bit of a misnomer as access can be given to any other beneficiaries of the trust.
Now that Inherited Drawdown has been created, keeping funds outside of the beneficiary’s estate is achieved using that method so there is less need for a bypass trust. If this is something that has been set up in your planning then it would be useful to review if it is still necessary.
Additionally bypass trusts can make loans to beneficiaries which is repaid to the estate on the death of the beneficiary, thereby reducing the beneficiary’s estate for IHT.
When comparing the merits of bypass trusts against inherited drawdown it is important to factor in that there will also be tax charges on both income and gains on the investments within the trust which would not arise if the money is kept within the pension wrapper.
Is Inherited Drawdown always the best option?
Possibly not, especially if you want more control over who benefits from the pension fund. Bypass trusts put a client’s own trustees (rather than the trustees of the pension fund for Inherited Drawdown) in charge over who benefits, and when. The trustees can be guided by a letter of wishes from the deceased.
This gives ‘control from the grave’ to the pension holder, especially in the case of complicated family structures or where there are children from previous relationships. Inherited Drawdown will in most circumstances provide more tax efficient and simple wealth transfer options than a bypass trust, but the Inherited fund could be withdrawn and spent by the nominated individual, or ultimately nominated to another successor whom the original pension holder would not have approved.