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Pensions and Inheritance Planning

19/04/2023

On 29 September 2014, the Government announced changes that would allow anyone to inherit a pension fund on death without incurring a 55% tax charge. Since that time, inheritance tax thresholds have remained frozen and rising property and asset prices have brought an increasing number of people into the 40% inheritance tax net.

As a result, many people will now often be advised to spend assets within their estate before accessing money purchase pension funds. This is because the pension will usually have the most favourable tax treatment on death.

On death before age 75, a money purchase pension can normally be passed to a beneficiary free of tax. If death occurs after 75, it will be taxed as the beneficiary’s income under PAYE. As long as a discretionary process is used to determine the beneficiary, the pension will generally be outside the estate for inheritance tax purposes.

Older couple sat on a park bench enjoying something the woman is showing on her phone

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:  

  1. It allows the fund to grow in a largely tax free vehicle, outside the beneficiary’s estate for inheritance tax purposes. 
  2. 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.
  3. A beneficiary’s pension is outside the grasp of the annual allowance and lifetime allowance*, limits which can otherwise restrict pension accumulation.
* Since 6 April 2023, the lifetime allowance tax charge has been removed, with the lifetime allowance due to be abolished from the 2024/25 tax year.

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.