Techzone

With the LTA consigned to history after April, attention is turning to how the new pension rules will operate and how this might affect retirement advice. One area set for a big shake up is the taxation of pension death benefits.

HMRC have issued draft legislation containing new allowances which cap the amount of lump sums which can be paid tax free. But accompanying that draft legislation was a policy paper which indicated that they plan to tax income from inherited drawdown and annuities purchased from funds where the member died before age 75.

Faced with the choice of a tax free lump sum or taxable income, many beneficiaries may be too quick to ditch the protection which the pension wrapper offers. Getting the right advice at this critical stage will be vital.

It’s important therefore that advisers are aware of what the planned changes are, what is still to be confirmed and how this could impact future advice.

While there will no longer be an LTA test on pension benefits at age 75, it still remains a pivotal age in terms of pension death benefits.

Death before age 75

From 6 April 2024, the LTA will be abolished and replaced by a new regime. At this time, the draft legislation only covers the treatment of lump sums paid out during the members lifetime and on death. This is still subject to consultation.

The draft legislation was accompanied by a policy paper which made proposals for the treatment of funds designated for drawdown or used to purchase an annuity.

Lump sums on death

The cumulative cash value of all tax free cash and other lump sums paid out during the member’s lifetime or on death will be tested against a new allowance called the ‘Lump Sum and Death Benefit Allowance’ (LS&DBA). This will be set at the same level as the LTA - £1,073,100 for those who don’t have any of the LTA protections.

With regards to lump sums paid within two years of death, anything falling within the allowance will be tax free. Anything exceeding the allowance will be taxed at the beneficiary’s marginal rate of income tax. If there are several beneficiaries, HMRC will determine how the charge is apportioned. There would appear little reason to deliberately defer paying the death benefits from uncrystallised funds until after the two year period as there is no longer an LTA charge to avoid.

The main difference to the LTA regime is that it doesn’t matter whether the lump sum is paid from crystallised or uncrystallised funds – both will count towards the new test. Previously, there was no LTA testing on death benefits paid from crystallised funds – they could be taken tax free.

Inherited drawdown and annuities

The policy paper suggests some crucial changes to the taxation of death benefits taken under inherited drawdown or used to purchase an annuity.

Where the funds used come from the deceased member’s uncrystallised savings, it's proposed that any income taken by a beneficiary will be fully taxable as their income. It will no longer be tax free as it is now. Broadly, this takes us back to how similar income payments were treated before ‘Pensions Freedoms’ in 2015.

Unfortunately, the policy paper doesn't deal with how such payments will be taxed if they come from the deceased member’s crystallised savings. Will they also be taxable or remain tax free – we will have to wait and see. However, with benefit crystallisation events becoming largely obsolete, it is hard to see a motive for retaining separate tax treatment for death benefits paid from crystallised and uncrystallised funds.

A further unanswered question relates to whether drawdown funds already with tax free status will be protected, and from what date?

Death after age 75

Essentially, there are no changes to how death benefits are taxed where death occurs after age 75. Beneficiaries will be taxed at their marginal rates of income tax whether benefits are taken as a lump sum, inherited drawdown, or used to purchase an annuity. As with the LTA, the new LS&DBA test falls away at 75, and so no tax-free lump sums will be available to individuals on death. This is the case whether funds have been crystallised or not.

This is likely to be the scenario for most clients as the latest life expectancy for both males and females at all adult ages is over 75 years.*

Potential advice issues

With the rules yet to be fully formed, it makes advice difficult.

We know how death benefits will be treated for deaths in the current year. But how could the new rules affect how beneficiaries take their benefits?

However future death benefits are taxed, clients should ensure that they are in a contract that provides all the options to give them choice. It's also important to remind them to nominate their chosen beneficiaries, and to update current nominations if these are no longer appropriate.

Nominations are not binding on the scheme administrators. They will use their discretion over who is to benefit and will typically liaise with the intended beneficiary to agree whether the death benefit is paid as a lump sum or income. However, if that beneficiary is a non-dependant, the only option may be a lump sum if the deceased hadn’t nominated them.

Clients should make sure they are in a contract that can provide all the options for taking death benefits, making sure that they also nominate their chosen beneficiaries. Such nominations can normally be changed in the future if circumstances personal or otherwise change. But having the flexibility is key.

The tax-free status on some or all of any pre-age 75 death benefit lump sums may encourage clients to choose this option over taxable income from drawdown. But this decision must be balanced against the fact that retaining funds in drawdown will continue to offer protection from IHT as well as maintaining the tax-free status on income and gains from the underlying investments.

There may also be a temptation to pre-empt legislation and crystallise all benefits this year while the LTA charge is zero. This may avoid an income tax charge on death benefits lump sums if death were to also occur in this year. But as we have said, there is no guarantee at the moment that beneficiaries’ pensions paid from crystallised funds will be tax free from next year if taken under drawdown or as an annuity.

In addition, from next year, death benefit lump sums will be tested and taxed in the same way whether they come from crystallised or uncrystallised funds and so crystallising now wouldn’t appear to provide an advantage either. It would also force clients to take their tax-free cash earlier than needed and potentially expose them to IHT. And there is still no guarantee that crystallised funds taken as inherited drawdown will continue to be available tax free.

Summary

We know how death benefits will be tested and taxed for any deaths in the current year. However, there are still many gaps in the draft legislation to filled before we can be confident of the taxation of all the options for death benefits, particularly should a client die before age 75. Hopefully the picture will become clearer later in the year, and we shall keep you up to date with any developments on Techzone.

* National life tables – life expectancy in the UK - Office for National Statistics (ons.gov.uk)