Gareth Hughes explains the issues retirement planners and their clients need to consider when passing pension wealth to future generations.
The introduction of pension freedom and the ability to pass on funds as continuing flexi-access drawdown to chosen beneficiaries has created planning opportunities for tax efficiently passing on pension wealth to future generations.
However, such planning may not be appropriate for all clients.
The tax facts
Before pension freedom, it was usual to use a “bypass” trust for tax planning with pension death benefits. But when it now comes to paying death benefits, there is no longer any tax advantage of using a trust compared to flexi-access drawdown; in most cases there is a tax disadvantage.
Taxation of death benefits in flexi-access drawdown
When flexi-access drawdown is set up for a chosen beneficiary:
• There is no charge on the fund if the member dies before age 75 and benefits are paid within two years of the date the scheme administrator was notified of the member’s death or could have reasonably have known of the death.
• There is no charge on the fund if the member dies on or after age 75.
• The drawdown fund is not normally subject to income or capital gains tax as it is still remains in a pension environment.
When an income withdrawal is taken by the beneficiary:
• There is no income tax where the member died before age 75 and the benefits are paid within two years of the date of notification
of the member’s death or could have reasonably have known of the death.
• Income tax is due at the recipient’s marginal rate where the member died on or after age 75.
• As the drawdown fund is not treated as being in the estate of the beneficiary, it will not be subject to inheritance tax.
Taxation of lump sum death benefits paid to a trust
When lump sum death benefit is paid to the trustees of a trust:
• There is no tax charge if the member dies before age 75 and benefits are paid within two years.
• There is a tax charge of 45% if the member dies age 75 or above.
• Investment growth (income and gains) are taxed at the trustee rates.
• The trust may have to pay exit and periodic charges in the future.
• Where the member dies on or after age 75, a special lump sum death benefit charge must be paid. Any payments to beneficiaries will be made with a 45% tax credit, and taxed at the beneficiaries’ marginal rate of income tax.
It is clear from this comparison that flexi-access drawdown is the more tax-efficient option. If funds are paid out of the trust within two years of the member’s death, the difference is likely to be minimal.
This is because there is limited opportunity for growth (taxable within the trust) and no 10-year periodic charge.
But if the funds are held over longer periods, the taxation of the growth and any periodic and exit charges will reduce the benefits available to the beneficiaries.
Efficiency issue
Are trusts for pension death benefits no longer required? Does the tax efficiency offered by flexi-access drawdown mean that trust planning with pension death benefits is a thing of the past?
From a pure tax perspective, it would appear so. But with 42% of marriages ending in divorce, let’s look at a practical case study to illustrate how the extra control offered by using a trust may well out weigh the tax efficiency of flexi-access drawdown for some clients.
Peter’s objectives
Peter is discussing with his adviser the options for his pension fund on his untimely death. He has not thought about what will happen to his fund when he dies and has not made an expression of wish (see Fig.1, above).
But he is clear that he wants his pension fund to be treated in the same way as his other investments that will be administered by his will when he dies.
Peter wants to provide for Alice during her lifetime if he dies first and any remaining capital to go to his children from his first marriage on Alice’s subsequent death or should she remarry.
Flexi-access problems?
Peter’s adviser explains that if they use an expression of wish naming Alice as the beneficiary, she will have full control of the fund. This means that she could, if she wants withdraw the whole fund during her lifetime.
In addition, she does not have to name Peter’s children on her expression of wish which deals with who benefits from any residual fund on her death.
Peter says he is not sure Alice would pass any remaining funds onto his children. In fact, he is fairly confident she would name her own children instead.
Using a pension trust
Peter’s adviser discusses the potential advantages of using a trust and points out that it is not necessarily as tax efficient as flexi-access drawdown.
However, it allows Peter a greater degree of control in appointing his own trustees to make sure his children benefit from any residual pension funds after Alice’s death.
The adviser also explains the advantages of using an “integrated trust” rather than a bypass arrangement. With the latter, the trust will receive only the death benefits if the scheme administrator exercises their discretion in favour the trustees of the bypass trust.
With an integrated policy trust, any lump sum death benefit will always be paid directly to the trustees of the trust. Peter understands that using the trust is about control rather tax efficiency and prefers the certainty of control offered by the integrated trust solution.
Peter completes the integrated trust deed naming Alice along with his two children as default beneficiaries and appoints his own trustees.
He also attaches a letter of wishes for the trustees. This will set out what benefits he wants Alice to receive during her lifetime, and that the capital should be used for the benefit of his children when she dies or remarries.
Reviewing Peter’s trust
Peter’s adviser explains they should regularly review the appropriateness of the trust. They may need to alter Peter’s planning strategy if, for example, Alice dies first and Peter is happy to revert to a simple expression of wish.
With an integrated trust, this can be achieved simply by directing the scheme administrator to pay death benefits as flexi-access drawdown rather than a lump sum and completing an expression of wishes form detailing who should be considered to benefit form the flexi-access drawdown.
In summary, using an expression of wishes form and passing on death benefits as flexi-access drawdown will often be the most appropriate and tax efficient solution for most clients.
But for some clients, using a trust and appointing their own trustees to decide who will receive the death benefits will be a preferred option.
Using a pension trust is all about control rather than tax efficiency and an integrated-type trust gives total control as lump sum death benefit will always be paid directly to the trustees of the trust.
Gareth Hughes is senior financial planning manager at Aviva
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