24th March 2015 at 9:10am
New rules from 6th April are a welcome development for many whose pensions can now be inherited free of tax, with pension wealth passed down the generations. Julie Hutchison, consumer finance expert, explains what you need to know.
New inheritance rules
The shift in the pensions landscape is not just about more flexible access for you – it’s also opened a door to how your loved ones can benefit after you’re gone. If you have a modern pension such as a SIPP (a self-invested personal pension), you’ll be able to nominate anyone to inherit your remaining pension fund as a drawdown account. This basically means flexible income, so the beneficiary can dip into the pension pot they inherit as and when they want, if the pension company is ready to cope with the new pension freedoms.
Zero tax for some, reduced tax bill for others
From 6th April, where someone dies before age 75, their remaining pension pot can be passed on to beneficiaries to access this pot tax free, as and when they wish. And that beneficiary doesn’t have to be aged 55 to start accessing it. Previously, this pot may have been taxed at 55%, so reducing this to zero boosts the wealth which can be passed on. Where someone dies after age 75, normal income tax rates of between 0% and 45% apply to cash taken out from the inherited pension, depending on the income of the beneficiary.
Don’t sleepwalk into a tax bill
If a beneficiary takes the whole pot of money as a lump sum, tax at 45% may automatically apply. The key is for beneficiaries to reflect carefully before deciding how much, and when, to draw down.
Inheritance tax isn’t usually charged on money held in a modern pension. But as soon as you take money out, that cash is inside your estate which means it’s inside the net for inheritance tax, if your estate pays this tax. This applies to the original pension owner and beneficiaries too.
Cascading wealth down the generations
‘Next generation’ beneficiaries can also name their own beneficiary who will take over the drawdown fund following their death. This enables pension wealth to be handed on, for example to grandchildren. It does however rely on a pension company being able to offer nominee drawdown accounts, as we do.
The inherited pension fund continues to enjoy the potential for tax efficient growth while the funds stay invested within the pension. And each time a pension fund is passed on after someone dies, the tax rate will be reset by the age at death of the last drawdown account holder.
Not all pensions offer flexibility
If you have one of the older styles of pension, it may not have the facility for you or your beneficiaries to access drawdown, so you may need to upgrade to a more modern pension which does, if you want the flexibility described earlier. Do keep in mind that valuable guarantees sometimes apply to older pensions. And there may be inheritance tax consequences if you transfer a pension while in serious ill health. Make sure you have all the information to hand before making any transfer decisions.
Take more control of your pension legacy
Do remember that your Will doesn’t normally control who inherits your pension. Your pension company usually makes the final decision, with reference to a Beneficiary Nomination form you complete, indicating your preference. It’s vital to make sure your Beneficiary Nomination is up-to-date, so it can be taken into account. It’s possible to do this online for some pensions. Alternatively you can request a form from your pension company.
In the past, a pension was often a fixed income for life. Now, with more flexibility both during your lifetime and for your loved ones later, a pension gives you options to save, spend and pass on your wealth tax efficiently.
Case study: how it works
Tom and Barbara are married, with an adult son, Charles. Tom has a SIPP worth £400,000. He names Barbara as his pension beneficiary. When Tom dies at the age of 73, Barbara can start to take a tax-free income, or not as she prefers, from the SIPP. Barbara then names son Charles as her pension beneficiary. When she dies at the age of 80, the unspent pension pot becomes available for Charles to access. As Barbara was over the age of 75 when she died, Charles will pay income tax on what he takes out of the pension pot. Charles is a basic rate taxpayer, and takes a regular income from the pension pot of a level still within his 20% income tax band. If Charles withdrew the whole remaining pot in one go, he could well pay tax at 40% or 45% on it.
This article is not financial advice. A pension is an investment. Its value can go up and down and it may be worth less than you paid in. Laws and tax rules can change in the future. This reflects our understanding at February 2015.