Using your pension pot as a tax free way to pass on wealth

Having introduced auto-enrolment in an attempt to improve pension saving in the UK, it seemed fitting that the government reform pensions per se to make them a more appealing option.  The Budget delivered in March 2015 certainly did not disappoint in this respect.

Commencing April 2016, savers will have full access and complete flexibility over their pension pot with the requirement to buy annuities abolished.  Individuals will be able to decide exactly how and when to spend their pension, even being able to draw the entire fund at once should they so wish.  In addition, individuals will be able to decide to whom they wish to bequeath any remaining funds from their pension pot.

With this increasing flexibility also came positive changes to the taxation system, generating what could prove to be the most revolutionary change yet – the potential to use pensions as a way to avoid Inheritance Tax.

Although pensions do not form part of someone’s ‘estate’ for IHT purposes, any unused pension assets were previously taxed heavily, at 55%, when passed on at death.  Without any kind of tax free band to take advantage of, every £1 of an inherited pension was taxed at this rate.  However, as of April 2015, this hefty and unpopular ‘pension death tax’ was abolished.

Under the new regime, should an individual die before they reach 75, all remaining pension funds will be paid to their chosen beneficiaries completely free of tax.  Continuing with this theme, any funds remaining when these beneficiaries die will also be passed on tax free.

Prior to April 2016, lump sum pension funds belonging to those aged 75 and above will be taxed at 45%, although there is the option for beneficiaries to receive a pension, on which they will pay their marginal rate of income tax, rather than the draconian 55% ‘death tax’.

The situation changes once again post April 2016 for those who die aged 75 and above.  All unused pension that is passed on will be taxed at the beneficiary’s marginal rate of income tax, regardless of whether funds are taken as a lump sum or pension drawdown.

Not only do these changes give beneficiaries the opportunity to manage the way in which they access the inherited pension fund, thus enabling them to do so as tax efficiently as possible, but aligning the position of the original pension-pot owner with the beneficiary in this way could prove extremely advantageous.  It could, for example, enable generations to plan together to share wealth and savings, bypassing a costly IHT bill.  In addition, older earners may well be incentivised to top up their pensions, again shielding their cash from a 40% IHT bill.

It is clear from the above that pension reforms are proving an important and valuable IHT planning tool but, of course, a more pressing issue for many is that of funding long-term care, especially given our ageing population.  These reforms also appear to tick this box as by abolishing the death tax, individuals may well be deterred from spending their pension funds too soon as money withdrawn straight away would be subject to income tax.  Keeping more money in a pension for longer could benefit those individuals by providing a source of funds should they need to pay for care in later life.