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03 December 2014

Changes to death benefits will allow pensions to be passed from generation to generation.

Next April’s changes to pension legislation further increase the appeal of saving for retirement through pensions, but need to be understood to ensure people take appropriate action.

 In the second of two articles on the new rules, Andrew Stokes, Head of Pensions at St. James’s Place, gives his views on the changes to pension death benefits and also explains why those with larger pension funds need to be vigilant.

The changes to pension death benefits had a lot of press coverage. Can you explain what the changes actually mean?

The changes relate to taxation of your pension when you die and how your dependants can inherit the money. The draft legislation that initially came out from the government only looked at one aspect of it – lump sum death benefits.

So, with regard to lump sum death benefits, if you die before age 75 with ‘uncrystallised’ pension funds in defined contribution schemes – i.e. a pension fund that has not been used to provide benefits – there will be no tax to pay. What’s changed is that if you die before age 75 with ‘crystallised’ funds – i.e. a pension fund that is being used to provide benefits through income drawdown – there will similarly be no tax to pay. Furthermore, if you die after 75, the 55% tax rate that applies today drops down to 45% from April 2015. Interestingly, it’s not the date of death, but the date that the claim is settled that determines whether the new tax rate applies.

This is really good news and a dramatic improvement on the current tax situation after age 75.

 What’s the tax position if the inherited pension is taken as income rather than a lump sum?

It’s a complex area which underlines the need for advice. Although it is still going through Parliament, the draft legislation proposes that pensions can be ‘inherited’ both by financial dependants and by non-dependants (‘nominees’). If the pension scheme member is aged less than 75 when they die, the dependant or nominee will not pay tax on the income. On the other hand, if the member is 75 or older when they die, the dependant or nominee will pay tax at their marginal rate.

On the death of the dependant or nominee, the pension can then be inherited by a ‘successor’. If the dependant or nominee is under 75 when they die, the successor will pay no tax on the income. However, the successor will pay Income Tax at their marginal rate if the dependant or nominee dies aged 75 or older. If the original member dies before the age of 75, but the dependant or nominee is aged over 75 on their death, the successor will pay Income Tax at their marginal rate.

If someone is a member of a defined benefit (final salary) scheme, should they consider transferring to a defined contribution scheme to improve their death benefits?

If we focus on the point of view that the fundamental purpose of a pension is to provide you with an income for life, why would you come out from a defined benefit scheme? There will always be exceptions, but the primary purpose of a pension is not to provide death benefits. You would be sacrificing income for life and improving benefits for when you’re dead; unfortunately you won’t be there to enjoy it.

Is the lifetime allowance, which sets a limit on the overall size of your pension benefits, becoming more of an issue?

Yes, it’s an issue for a small number of people. As the lifetime allowance has come down from £1.8m, then £1.5m and now to £1.25m as at April 2014, this is likely to become more of a problem in future. You don’t necessarily need a very big fund today to hit those numbers in future, depending on your term to retirement, and depending on the growth rate that you’re going to achieve. For example, someone with 25 years to go would hit the £1.25m lifetime allowance if their fund was £291,000 today and their funds achieved growth of 6%* a year after charges.

At the moment there’s an opportunity to maintain a higher level of lifetime allowance if the value of your pension was over £1.25m on 5 April 2014, through ‘Individual Protection 2014’. If people think it might be a problem for them in the future they should seek advice, but most people don’t have that worry. It would be great if they did.

Do you think more people will now invest for their retirement through pensions?

Pensions are in the news and being talked about, which means people are more engaged with retirement planning. The fact that you get tax relief on the money you put into a pension, and you get 25% of your pension back as tax-free cash, means you’re effectively getting tax relief on tax-free cash. From April you will have the freedom to access as much of your pension as you like from age 55. With all these benefits, why wouldn’t you invest for your retirement through a pension? 

The levels and bases of taxation, and reliefs from taxation, can change at any time.

The value of any tax relief depends on individual circumstances.

*This figure is for example purposes only and not guaranteed. Any rate achieved may be higher or lower than this. What you get back depends on how your investment grows.

Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.

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