Way back in March 2023, before our gloriously changeable British summer, Chancellor, Jeremy Hunt set out his plans the abolish the pension ‘lifetime allowance’.
This was met with welcome noises from pension savers and pensioners alike, even if some thought privately it could be too good to be true.
The Institute of Fiscal Studies (IFS), the UK’s leading economic research institute, however, labelled the decision ‘bizarre’!
They exclaimed removing these pension limits ‘widens inheritance tax loopholes for the wealthy.’ The wealthy can now build their pensions to even higher levels and pass it on to their loved ones, tax free, when they die. The IFS said the purpose of a pension is to provide retirement income, not to avoid tax.
The Treasury moved quickly to defend the lifetime allowance removal. They explained that Increasing the annual allowance and removing the lifetime allowance would encourage many professionals, such as GPs and NHS Consultants to stay in their jobs and defer retirement.
Fast forward to September and we now see the IFS has probably had a big influence on the new pension legislation. The tax collector is now looking hard at your pension and in particular their favourable tax treatment on death.
Nothing is yet finalised beyond April 2024, we know how pensions are taxed until 5th April 2024, but from next tax year, there is still some small print for HMRC to sign off.
What we know so far
HMRC have issued draft legislation containing new allowances which cap the amount of lump sums which can be paid tax free from your pension. That cap applies to the tax-free cash lump sums taken by the pensioner during retirement and a cap on lump sum death benefits.
Accompanying the draft legislation is a policy paper which suggests HMRC plan to tax income from inherited drawdown and annuities purchased from funds where the member died before age 75.
These are currently tax free.
Death before age 75
From 6 April 2024 we have the new regime, free from the ‘lifetime allowance’.
All lump sums paid from a pension 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 lifetime allowance – £1,073,100 for those who don’t have any of the lifetime allowance protections.
The main difference to the lifetime allowance regime is that it doesn’t matter whether the lump sum is paid from drawdown or non-drawdown funds, both will count towards the new test. Previously, there was no further testing (and no tax) on death benefits paid from drawdown funds as they had been tested on the member when they first drew down.
The policy paper suggests some big changes to the taxation of death benefits taken under inherited drawdown or used to purchase an annuity. If the funds come from an uncrystallised pension any income taken by a beneficiary will be fully taxable as their income. It will no longer be tax free as it is now.
The policy paper doesn’t give us the complete picture, there are still some gaps in the new regime that require filling. We don’t yet know how such payments will be taxed if they come from a drawdown pension.
Will they also be taxable or remain tax free? We will have to wait and see but my guess is there will not be separate tax treatment for death benefits paid from crystallised and uncrystallised funds.
A further unanswered question relates to whether current inherited drawdown funds already with tax free status will be protected, and from what date?
I hope they are. It affects a number of our clients.
Death after age 75
There are no changes to how pension 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 lifetime allowance, the new Lump Sum and Death Benefit Allowance 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.
Areas where you will need advice
As the rules are 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?
Review your pension contracts.
As we cannot control how death benefits are taxed in the future it’s never been more important to ensure that your pension contract provides all the options and choices.
Choice in terms of how to take tax free cash and income during retirement and choice in terms of allowing beneficiaries to take their inheritance in the most tax efficient way for them.
There are many pension contracts that restrict how benefits are taken. These should ideally be avoided. Our recommended pension structure are extremely flexible and retain all the key options for you.
Complete your ‘nomination’.
It’s crucial to make sure that you nominate your chosen pension fund beneficiaries, and to update current nominations if these are no longer appropriate.
Nominations are not binding on the pension 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.
If that beneficiary is a non-dependant, the only option may be a lump sum if the deceased hadn’t nominated them. Nominations need to be written correctly to aid tax efficiency and choice.
If you are a beneficiary of a pension, take advice immediately and review options.
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.
Don’t try and be too clever!
There may also be a temptation to pre-empt legislation and crystallise all benefits this year while the lifetime allowance charge is zero.
But, 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 doesn’t appear to provide an advantage.
It would just mean taking the tax-free cash earlier than needed and potentially expose them to Inheritance Tax.
Summary
We know how death benefits will be tested and taxed for any deaths in the current year. There are still 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.
What we believe will be the case is:
- Tax free lump sums will be capped at the current lifetime allowance figure, £1,073,100 per individual.
- Any pension income taken by a beneficiary will be taxed to income on the beneficiary.
- Any lump sum payment over the cap will be taxed to income on the beneficiary.
Hopefully the picture will become clearer later in the year, and we’ll be sure to keep you up to date with any developments.
