In April 2015, George Osborne completely overhauled pensions and radically changed the way in which you can access them. This was appropriately entitled ‘Pension Freedom’.
Subsequently, some press articles predicted that there would be a surge in the sale of Lamborghinis, as we were no longer restricted on how much we could draw out from our pension pot.
While it is true that there has been a significant uptake in people accessing their pensions, the majority accessed them purely to support their retirement income. What has become apparent is that many people draw from their pensions first, leaving their other assets and savings intact, stemming from a belief that this is what a pension is for, to support them in their old age. What therefore appears to be missed, is that there are many other changes that have also been introduced, in particular with respect to how pension funds are treated when someone dies. Therefore, when you retire and you require some additional financial support, you should ask yourself: out of all my savings and investments, what should I spend first?
How pensions are treated when you die
Before ‘Pensions Freedom’ was introduced, for anyone below the age of 75 only uncrystallised funds, i.e. funds which have not been cashed in via drawdown or an annuity, could be paid out tax free. Pension funds which had been accessed and placed into a drawdown arrangement would suffer a lump sum death charge of 55%, unless inherited by a spouse or dependent child who continued with drawdown. Even then, any withdrawals would be taxed at their highest marginal rate. Therefore, drawing a lump sum death benefit created its own problems by increasing the potential future Inheritance Tax liability of the beneficiary.
The good news is that the new rules allow you to pass your pension wealth on in a very tax efficient way. Furthermore, you can now leave your pension to anybody, whether that be a loved one – member of your family – or a random person in the street. This enables you to pass your pension on to future generations such as children, grandchildren, a close friend and beyond.
Another advantage is that the pension stays within the wrapper, thus continues to build up tax free and is outside the beneficiary’s estate when they die. Although death benefits can be paid out as a lump sum, annuity or a drawdown fund, the tax treatment depends on the age of the donor at their date of death:
- Before age 75: benefits available are tax free
- Age 75 onwards: benefit is taxed on the beneficiary’s highest marginal rate of income tax
Taking advantage of the rules on passing on pensions when you die
With some sensible planning, as stated above, your pension does not need to form part of a beneficiary’s estate on death. Rather than receive a lump sum on death, your beneficiary could choose to keep the pension fund and carry on drawing from it as and when required. Again as mentioned above, if the donor was under age 75 when they died, this income will be tax free but if they were over the age of 75, any income taken will be taxed on the recipient’s highest marginal rate. Please note, this can only happen if your pension provider has adopted the new rules.
Some providers will only offer this to named beneficiaries on your expression of wish form. Therefore, it is important to check if your provider can accommodate this and equally, it is also important to ensure that you complete an expression of wish form.
If so desired, you will be able to name more than one person, beyond your immediate dependants, whom you would like to benefit from your pension in the event of your death.
To draw or not to draw your pension
This now brings us to the penultimate question of when to draw your pension benefits. As your pension does not form part of your estate, drawing an income from it may mean you are inadvertently increasing potential Inheritance Tax due when you die. This is because your taxable estate will not be reduced in size as you are not drawing from it.
To put it differently, for every £1 you actually receive in your pocket after paying income tax, 40 pence of this could ultimately be lost as Inheritance Tax. This is a lot of unnecessary tax to pay!
So what can be done as an alternative? Well the simple answer is to consider spending assets that count towards Inheritance Tax such as collective investments, ISAs and savings. Using these assets will achieve two things; firstly, by depleting your estate outside your pension, you are actually reducing your potential Inheritance Tax liability by up to 40 pence for every £1 spent; secondly, your pension continues to remain outside your estate and continues to grow in a tax privileged environment, free of Capital Gains, Income and Inheritance Tax. That said, funds within a pension can fall in value depending on the underlying performance of the investments held within it.
This is clearly a simplistic way of looking at it and this article does not constitute personal advice as each individual circumstance is likely to be different. Factors that will determine whether you are better drawing from your pension are:
- Availability of savings outside your pension
How close you are to breaching your lifetime allowance
- Future plans, such as moving abroad
- State of health
- Personal tax status (if your marginal rate of tax is lower than your intended beneficiaries’)
Desire to make gifts out of tax-free cash and/or income so you can see your dependants enjoy them in your lifetime
Hence it is not a straightforward question to answer and one size certainly does not fit all. So, as you approach retirement, it is important to seek advice to fully understand what your options are, as well as the potential consequences of each choice.
Prevailing tax rates and reliefs depend on your individual circumstances and are subject to change.
How Tilney can help
Tilney’s financial planners help people make informed decisions about their finances. If you’d like to speak to a local financial planner about your circumstances, we offer free initial consultations over the phone. We can’t give you advice during these consultations but we can provide guidance and, if you think you’d benefit from personalised financial advice, we can talk you through the options and explain the costs. You can book a consultation online or give us a call on 020 7189 2400.
This article was previously published on Tilney prior to the launch of Evelyn Partners.