James Bailey looks at some practical implications of the massive changes in the rules governing tax and pensions that took place in April 2015.
Before the changes in April, there was limited scope for inheritance tax (IHT) planning relating to pensions, and in many cases there were more problems than opportunities where pensions were concerned. Pension funds do not form part of your estate for IHT purposes, but they have their own system of tax charges on your death.
Out with the old…
In the case of personal pensions, there might be a substantial cash sum within the pension fund, and under the old rules, this could only be passed to your heirs free of tax if you died before reaching the age of 75, and you had not started to draw down any of the money in the pension fund.
‘Drawing down’ a pension is the alternative to buying an annuity – it involves taking money out of the fund and it being treated as income for tax purposes. Until April 2015 there were limits on how much you could draw per year, but now the only limit is that what you draw will be treated as taxable income.
If you had drawn down anything from the fund, what was left was subjected to a tax charge of 55%.
In the case of ‘dependants’, this could be avoided by them receiving income (taxable on them in the normal way) instead of taking the money as a lump sum, but for someone of pensionable age the only dependant they were likely to have was their spouse – and once they were gone, their surviving spouse would usually have no ‘dependants’.
If you died after reaching 75, the 55% charge applied even if you had not started to draw down the pension, though if you had any ‘dependants’ they could take income instead of capital as described above.
…in with the new
Under the new rules that apply from April this year, if you die before the age of 75, your pension pot can be passed tax-free to your heirs, whether or not you have started to draw down on it. If they wish your heirs can leave the money in the pension fund, where it will continue to grow in a tax-free environment, and draw down on it without limits. The money they draw will be free of tax in their hands. Assuming they can resist the temptation to draw the entire fund out at once, they will be getting tax-free income from an investment that is itself also tax-free.
This treatment is not confined to ‘dependants’ – it is available to any heir who is left the pension pot.
This, incidentally, is probably the final nail in the coffin of the much hated annuity, because these generous rules only apply if the pension is untouched or is in drawdown, not if it has been used to purchase an annuity. The income from the annuity will be taxable in the normal way.
If you live beyond 75, your heirs will suffer a 45% tax charge if they take the cash lump sum, but they can instead elect to receive the fund as income via drawdown – though this time the amounts drawn will be taxable as income.
Practical Tip:
Those without significant pension pots are constrained by the annual limit on pension investment of £40,000, but if you have a significant pension pot, and you have sufficient income not to need to draw down on it, you no longer need to try to reduce it in order to avoid the 55% tax charge. The fund will be a tax-free legacy if you die before 75; or a source of taxable income if you survive for longer. Pension advice from a suitably qualified specialist based on your own personal circumstances is recommended.
