By now, we’re all fairly well versed on the various flexibilities associated with ‘pension freedom’ legislation.
Pensions now have the potential to be an extremely tax efficient vehicle via which to transfer wealth. If you’ve built up a substantial pension pot and are able to retain as much of this as possible by drawing a retirement income from other sources (such as ISAs, collectives and bonds), you may think that you’ve got it sussed. By avoiding accessing your pension funds during your lifetime, less of your wealth will fall into your estate, thus reducing or mitigating Inheritance Tax liability. Furthermore, if you die before the age of 75, the entirety of your pension can be inherited free of tax (IHT and income) for your beneficiaries to access as they wish.
On the face of it, this is the case. But surely it can’t be that straightforward? There must be a catch somewhere! Indeed, there is some lesser-publicised small print.
In order to be able to benefit from all of the flexibilities, you’ll need to ensure the necessary requirements are in place. Let’s look at some of the issues that surround so-called ‘death benefits’, particularly pertaining to nominations.
Have you got the right pension?
Not all pension schemes can offer the full range of death benefit options. Some schemes have not adopted the full flexibilities or don’t have the systems in place to offer them. In fact, over the last few years I have reviewed countless contracts that will only provide lump sum death benefits. If a tax efficient legacy is important to you then you may need to consider moving your pension to a contract that will allow you to benefit from the full range of death benefits available under the current legislation. However, this decision shouldn’t be rushed into as your existing pension contract may have other very valuable features – such as guarantees, guaranteed annuity rates or enhancements to tax free cash – that need to be balanced against death benefit flexibility. Who said pensions were simple?!
Have you made the right nominations?
It is in fact up to the trustees of your pension to determine who should benefit from your pension on your death. This may sound worrying, but their discretion is important because without it, there could be significant and needless Inheritance Tax consequences.
A death benefit nomination, however, helps to guide the scheme trustees/administrators when exercising their discretion. The last instructions they receive will be used to guide their decision, so it’s vitally important that nominations are regularly reviewed. The more information you can provide regarding the payment of benefits, the better.
The rules now allow for someone who is not dependent upon the deceased (for example, their adult children) to retain the pension fund inside the tax efficient wrapper and draw an income as they require (this is commonly termed ‘inherited drawdown’).
But there’s a little known trap that can prevent this from happening. If there is a surviving dependant (e.g. a spouse or disabled child), inherited drawdown can only be offered to someone else if the deceased had nominated them during their lifetime. Without that nomination, their adult children, for example, won’t be able to choose inherited drawdown, meaning the only option is to pay them a lump sum. Although a lump sum might seem an attractive proposition, if death of the pension owner occurs after age 75 then this lump sum payment will be subject to the non-dependents’ marginal rate of income tax and could result in an eye-watering amount of tax due immediately and unnecessarily. Furthermore, the net amount received would then come out of the pension wrapper and form part of the non-dependents’ estate. Had they had the ability to move into inherited drawdown, they would have been able to nominate their own beneficiaries and the fund could have cascaded through generations to come without Inheritance Tax implications.
Issues may also arise where people nominate their spouse to inherit 100% of the benefit of their pension. Although this may be the right option in many circumstances, family life has undoubtedly become more complex in recent years. Those that have remarried and/or have children from previous relationships may want to re-visit their nominations to ensure their current spouse is taken care of upon first death, as well as leaving instruction for any remaining pension fund to be passed to their own children upon second death.
For those with large estates, building in some flexibility on first death is also important. If your spouse is never likely to need the value of your pension, it may be advantageous to allow your adult children to benefit from the fund upon first death as opposed to second death, which could occur much later on in life. If this nomination is in place and the pension holder dies before age 75, the full death benefits of the pension could be realised and the entire pot passed tax free into the beneficiaries’ hands.
Additionally, many people omit to specifically detail how they would want benefits to be treated if both they and their spouse died together.
The time is now
Whilst we cannot place any obligation on the trustees of your pension, a carefully worded nomination form can help to ensure there is some flexibility should the worst happen.
It’s easy to think that these decisions can be left until another time. However, an untimely death or the diagnosis of a serious illness can mean that what you would have liked to happen to your pension savings cannot be followed through.
Nominations can normally be changed at any time and should be regularly reviewed. Changes in your personal circumstances, how much your spouse needs in retirement, or reaching age 75 may all prompt a rethink on how benefits are to be distributed.