Maximising the benefits of an inherited pension
After the members death, it is often desirable to retain an inherited pension within a pension wrapper. This is because:
- It allows the fund to grow in a largely tax free vehicle, outside the beneficiary’s estate for inheritance tax purposes.
- If death occurs after 75, it means that the beneficiary does not need to incur a large income tax charge. For instance, a beneficiary’s taxable income for the tax year will often severely increase if paid as a lump sum. This can push someone into higher or additional rate tax and perhaps cause the loss of their tax free personal allowance.
- A beneficiary’s pension is outside the grasp of the annual allowance and lifetime allowance*, limits which can otherwise restrict pension accumulation.
To retain the fund within a pension, the beneficiary will need to qualify as either a dependant, nominee or successor of the member. Unless the beneficiary is the member’s spouse, partner or minor child, this will normally mean that any beneficiary will need to have been nominated.
Case study – Maeve, Harry and Rachel
Maeve (78) has died, leaving a £300,000 pension fund. As she was over age 75, the fund is taxable. She nominated her son, Harry (50), his wife, Rachel (48) and her grandchildren, James (17) and Carter (15) as potential beneficiaries - Her nomination states that she wanted Harry to be considered in the first instance.
Harry earns £55,000 and Rachel earns £30,000 a year. Each contribute 5% of their earnings to occupational pension schemes via salary sacrifice. Rachel receives child benefit for the children, although due to Harry’s earnings (being above £50,000), some of this is clawed back via the high income child benefit charge (HICBC). Their household income is as follows:
| Harry | Rachel | |||
|---|---|---|---|---|
| Chargeable | Payable | Chargeable | Payable | |
| Salary | £55,000 | £30,000 | ||
| Less Salary Sacrifice contribution | £2,750 | £1,500 | ||
| Gross Earnings | £52,250 | £28,500 | ||
| Personal Allowance | £12,570 | £12,570 | ||
| Basic rate tax @ 20% | £37,700 | £7,540 | £15,930 | £3,186 |
| Higher rate tax @ 40% | £1,980 | £792 | ||
| National Insurance | £52,250 | £28,500 | ||
| Employee NIC (12% between £12,570 - £50,270) | £37,700 | £4,524 | £18,620 | £2,234 |
| Employee NIC (2% above £50,270) | £1,980 | £396 | ||
| Child Benefit | £1,885 | |||
| Earnings above £50,000 | £2,250 | |||
| High income child benefit charge | £415 | |||
| Net deductions | £16,417 | £6,920 | ||
| Take Home pay | £38,583 | £24,965 | ||
Optimising the pension death benefit
Following feedback from the adviser, Maeve’s pension is divided so that James and Carter receive £25,000 each, with the remaining £250,000 shared between Harry and Rachel.
James and Carter expect to go to university in the next few years. Their respective £25,000 allocations will be used to provide them with a monthly income to support their studies. The income will fall within their available personal allowances, so can be taken tax free.
Harry and Rachel intend to use salary sacrifice to increase their individual pension contributions and reduce their earnings to £12,570 (subject to wages not falling below the national living wage). They will then use beneficiary’s drawdown income to increase their respective earnings to £50,000 each. This would have the following effect:
| Harry | Rachel | |||
|---|---|---|---|---|
| Chargeable | Payable | Chargeable | Payable | |
| Salary | £55,000 | £30,000 | ||
| Less Salary Sacrifice contribution | £42,430 | £1,500 | ||
| Pension Income | £37,430 | £37,430 | ||
| Gross Earnings | £50,000 | £50,000 | ||
| Personal Allowance | £12,570 | £12,570 | ||
| Basic rate tax @ 20% |
£37,430 |
£7,486 | £37,430 |
£7,486 |
| National Insurance | £12,570 | £12,570 | ||
| Employee NIC (12% between £12,570 - £50,270) | £0 | £0 | ||
| Child Benefit | £1,885 | |||
| Earnings above £50,000 | £0 | |||
| High income child benefit charge | ||||
| Net deductions | £49,916 | £24,916 | ||
| Take Home pay | £42,514 | £44,399 | ||
- Reducing the earnings has meant that Harry and Rachel no longer need to pay national insurance, yet crucially will still earn enough to build up state pension entitlement (the beneficiary’s pension is subject to income tax, but not national insurance).
- Since neither Harry or Rachel now earn above £50,000, they are no longer subject to the high income child benefit charge.
- This means that Harry and Rachel’s household take home income has increased from £63,548 to £86,913. An increase of £23,365.
- Although £74,860 of the beneficiary’s pension has been taken, an additional £55,610 has been paid into their individual pensions. Effectively, their total pension wealth has decreased by only £19,250.
- Unlike the beneficiary’s pension, the additional £55,610 paid into the pension will now benefit from a 25% tax free cash entitlement when eventually taken.
Comment
Ensuring a death benefit nomination names all potential beneficiaries is very important, but it is only one piece of the puzzle. When a scheme member does die, careful planning around the most efficient way to utilise the fund is also needed if benefits are to be maximised.
Important Information
Please note this is for general information only and is based on LV=’s understanding of the relevant legislation and regulations and may be subject to change.
The tax treatment of benefits depends on individual circumstances, and may be subject to change in the future.
The use of this document is at your own risk, and the content should not be used for the provision of professional advice.
LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.