Passing the pension fund through the family without inheritance tax
Passing wealth through the family, for most, is an important part of their inheritance planning process. Until recently, it has been problematic to include the pension fund in this process. Under the newly formed pension freedom legislation, which began on 6 April 2015, pensions can now easily be included.
There may be pitfalls along the way, with many outdated pension contracts not allowing this full flexibility.
Firstly, it is important to understand there is a difference on the tax treatment of how pension funds may be withdrawn, subject to the age of the member on death:
- Death of the pension fund member before age 75 allows for the inheriting individual to receive the pension fund as a pension fund in their own name without tax - they may also withdraw the entirety of this inherited fund without income tax, inheritance tax or capital gains taxes in their own name
- On death after age 75, the pension fund is passed to the receiving individual, again tax-free, but if they wish to withdraw it (as an income or a lump sum) they must pay income tax at their marginal rate
In both scenarios, the pension fund can be inherited as a pension fund, and no taxes incurred. Taxes may only potentially occur where a member died after age 75 and the capital of the pension fund is being withdrawn.
Naturally, under pension freedoms, an individual may choose when to draw pension income and when not to. This is slightly different between defined benefit and defined contribution schemes. Under a defined benefit scheme, there will be a standard retirement age, whereby benefits come into payment at that point (although you may retire sooner or later) and there is no capital sum as such to be inherited. In these scenarios, it is impossible to inherit a pension fund, rather there may be provision for a pension income to any spouse/partner/dependant. Prior to drawing the income, a transfer of benefits to a defined contribution arrangement may be elected, to allow capital to be inherited on death. This would involve the surrender of the final salary pension, so careful consideration is needed.
For a money purchase pension scheme, there is always a capital lump sum, if it has not been previously converted into an annuity (now voluntary).
There are a wide number of personal pension contracts and retirement annuity contracts that have automatic annuity purchase built into them at the selected retirement age of the individual. Under these contracts, holding them until retirement date will see the ability to transfer lost and an annuity automatically acquired. Accordingly, any individual wishing to delay the withdrawal of income from their pension fund beyond the standard retirement age of their current pension contracts should investigate if they are able to defer retirement, or indeed transfer the pension fund to an alternative arrangement that is able to help them reach their own personal objectives.
Annuity purchase may be available at a preferential rate, established at the start of the arrangement. A quandary then presents itself between drawing this rate (with little capital inheritance) or forgoing a potentially attractive annuity rate to allow for inheritance of capital.
Under certain pension contracts, retirement cannot be delayed past age 75. There are self-administered pensions known as SSAS and SIPP which provide the individual with the ability to defer income withdrawal beyond age 75, and thus increase the ability of the pension fund to be inherited.
Legislation permits for one individual to pass their pension fund to another and the recipient to do so as well. Accordingly, pension capital can cascade through a family tax-free on death (if not withdrawn from the pension wrapper) ad infinitum.
Naturally, careful consideration should be given to the type of pension scheme utilised, with self-administered pensions potentially offering flexibility in adding and removing members through the generations to achieve this objective.
By Adrian Mee, Consultant