The way we advise retired clients who are taking a “drawdown” income from a defined contribution pension fund was turned on its head four years ago.
Previously the most common advice to clients with other liquid assets had been to spend their pensions first. Any unspent pension funds were taxed at a rate of 55 per cent if bequeathed to non-dependent relatives, which compared unfavourably even to the 40 per cent rate at which Inheritance Tax (IHT) is currently charged.
Then, in September 2014, the former chancellor of the exchequer George Osborne announced the abolition of the 55 per cent tax on DC pension death benefits. Since April 2015 it has been possible for DC scheme members to pass on unused funds to anyone they like under very generous tax rules.
Cascading from generation to generation
If the pension scheme member is aged under 75 when they die then their beneficiary, or beneficiaries, can inherit and withdraw the entire pension fund entirely tax-free. If they die aged over 75 their beneficiaries will pay income tax on any withdrawals they make in the same way as they would on any other additional taxable income.
Most generous of all, if the beneficiaries keep the funds they inherit invested in a qualifying pension scheme they can themselves bequeath these on the same terms, as can those who inherit from them, in perpetuity. This potentially makes pensions a highly effective tool for multi-generational estate planning and means it can make sense for wealthy individuals to leave their pensions untouched for as long as possible and, in the first instance, spend other assets that may be subject to IHT.
Every silver lining has its cloud, of course. The combination of the lifetime limit on fund size (currently £1.03 million for anyone who has not “protected” an earlier, higher limit) and annual allowance (£40,000 for most people or £4,000 if you have started to take a flexible income from your pension pot) for contributions restricts the amount that the wealthiest families can transfer between the generations using pensions.
Nonetheless, the potential for a couple to pass on more than £2 million to their children tax-efficiently, in addition to the amount that can be bequeathed tax-free thanks to the IHT nil rate band (£650,000 per couple, potentially rising eventually to £1 million if they make use of the residence nil rate band), means that wealthier families should no longer consider pensions only to be a means of providing retirement income.
A word of caution, however. Politicians have tinkered endlessly with pensions for more than a generation, even during times of political and economic stability.
We cannot know how a future government might alter the rules governing death benefits so it would be prudent not to let the tax tail wag the investment dog too vigorously. Pensions should now form a part of many families’ estate plans but they should also be justifiable as a means of providing a retirement income in case the rules were to change again.
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