Abolishment of death tax opens financial planning opportunities

At the end of September, George Osborne announced a radical change to the tax laws on inherited pensions, which can make saving into a pension more attractive, especially for people with large incomes.

Existing tax rules state that pensions can be passed to beneficiaries, but tax is applied at 55% except in two instances, both applying only if the holder dies before the age of 75: if the pension holder had not touched the fund then it would be tax free, and if the beneficiary spent the money instead of keeping it contained within the pension they would pay tax at their marginal rate. These exceptions do not apply if the holder died after the age of 75, in which case the 55% tax would apply.

Under the current rules, pensions can be passed on but are not the most tax-efficient way to provide money for beneficiaries. By comparison, inheritance tax is 40% and applied only to estates worth £325,000 or more, or £650,000 for couples.

There's a reason the tax on pensions appears so high though, and that's because tax was not deducted when the money was paid in. Pensions benefit from tax relief, so if a basic-rate taxpayer contributes £80 to a pension, the government will add the £20 that would have been taken in tax. The 55% is meant to reflect the tax relief and the growth of the investments over the years.

The new rules that Osborne introduced change all this though. From next April, pensions will always be passed on tax free and tax is only applied if the holder dies after 75 and the beneficiary withdraws the money, at which point they pay their marginal tax rate. The following table explains the current and new rules:

  Current rules New rules
  Die BEFORE
75
Die AFTER
75
Die BEFORE
75
Die AFTER
75

Pension passed on and no withdrawals have been made, including tax-free cash

Tax free 55% tax Tax free Tax free

Pension passed on and money has been removed  or is in drawdown

55% tax 55% tax Tax free Tax free

Tax payable if beneficiary spends the money rather than keeping it in a pension

Marginal tax rate 55% tax Tax free Marginal tax rate

 

Combined with the pension freedoms that have been announced since the March Budget, pensions are now an attractive vehicle for saving and passing on wealth. Although critics to the change could point out that it is the very rich, who have enough money to live on from other investments, that can leave their pension untouched and let it pass on to beneficiaries for subsequent generations, the rules apply to everyone, so careful planning and talking over options with a financial adviser could prove beneficial for many.

The new rules do not put a restriction on how many times a pension can be passed on - it could have been stated, for example, that a pension could be left to a beneficiary once or twice, but the next recipient would pay a certain rate of tax on it. Unless new proposals are put forward before the changes come into effect, pensions will be able to pass on indefinitely, remaining invested.

That's the idea in theory, but in practice it is unlikely to work out that way very often. The very wealthy who would be able to afford to not touch their pension would already be able to afford specialist advice, which could see them put their money into various trusts, so this pension change is unlikely to result in a lot of money not reaching HMRC when it otherwise would have.

What's more likely is some people will have amassed a large enough pension to provide an income but have some left over when they die. There may also be people with modest pension pots, but who are able to live off their state pension and other assets so they can pass their pension fund to beneficiaries. This could be particularly appealing for parents of children with no pension provisions - they may want to help provide a pension in a similar manner to parents paying for house deposits.

This will be easier than ever thanks to the pension freedoms. The pension bank account will let people remove as much or as little from their pension as they want, so someone with a particular focus on leaving a pension for their children to retire with could try and live off their state pension as much as possible, and use small chunks of their private pension to top up their income without worrying about crystallising the entire fund. The pension would eventually pass down to the beneficiary, and the government would receive tax when that beneficiary started to withdraw money.

The pension freedoms will provide much more flexibility to pension holders, including financial planning to leave more to beneficiaries. The changes to restrictions and tax rates mean more options will be granted to people in many situations, not just the very rich, but professional advice will continue to help you understand all options and make your money go as far as it can.

Do you think the removal of the death tax is good news? Let us know with a comment below.

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The details provided in this article are for general information only and are in no way deemed to be financial advice. All of the material is correct as of the publication date, but could be out-of-date by the time you read the article. For our latest information and news, please see our articles section: https://www.portafina.co.uk/whats-new

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