Pension Reforms and IHT Planning

by George Hatjoullis

Some very dramatic pension reforms will kick in on in april 2015. The latest instalment transforms the whole nature of saving through defined contribution pension schemes. For those in income drawdown (or value protected annuities) it will be possible to bequeath pension assets to any named beneficiary free of any tax provided you die before age 75. For death after 75 the bequest is made at the bequest beneficiary’s marginal tax rate but they can draw an income from the pension request and thus control the impact on the marginal tax rate. These reforms have profound implications for IHT planning for those with substantial assets.

First, consider the tax-free lump sum of 25% of the pension value that it is possible to take at the moment on initiating a pension income. Is worth taking? The lump sum becomes part of the general estate once it is taken. If the value of the estate plus this lump sum exceeds any IHT potentially exempt amount, then the lump sum is potentially liable to the IHT rate, presently 40%. If the tax-free lump sum option is not taken then the funds remain within the income drawdown pension and can be bequeathed to a name beneficiary free of all taxes if death occurs before age 75 and can be drawn as income at the beneficiary’s marginal tax rate if death occurs after 75. It effectively means that there is some advantage and no disadvantage to maximizing the amount in one leaves in an income drawdown pension plan (or value protected annuity) on death. The exception to this is if you wish to give assets to inheritors prior to death in order to benefit from the 7 year rule. However, if you have assets in addition to the pension assets this is still possible, leaving you with an income and a tax efficient bequest option for the residual pension assets.

Second, consider the principle that is established for death after 75. The beneficiary receives the bequest and pays tax at her marginal tax rate, not the IHT rate. If the pension bequest is taken as income, the beneficiary can take the income at such a pace as to minimise the impact on her marginal tax rate, subject to the pension manager permitting and facilitating. This principle could be extended to all inheritance. Instead of taxing the sums bequeathed at a single rate, the bequest could be taxed at the recipient’s marginal tax rate. It is likely this pension reform is a prelude to making such changes for IHT, with a possible increase in the potentially IHT free amount.

Third, a major disincentive to save via defined contribution pension plans has been replaced by a major incentive. There is a tax advantage to investing in a plan (though this is being reduced) and no disadvantage. Previously the generous tax advantages to investing in pensions were offset by the tax disadvantages in deploying the pension and bequeathing pension assets. Indeed, unprotected annuities still go to the insurance company on death and not a designated beneficiary, so taking an unprotected annuity as pension income needs to be considered carefully. In my view it is probably never going to be a good idea. Also, defined benefit schemes are no longer quite as unambiguously advantageous as they do not share this bequest benefit.

Taken as whole the pension reforms make defined contribution/income drawdown a more attractive and logically consistent option for pension provision. Defined benefit schemes still have the attraction that the investment and longevity risk lies with the pension provider but defined contributions schemes are on the way out for precisely these reasons.

Value protected annuities ( )