HOW TO AVOID INHERITANCE TAX ON PENSION DEATH BENEFITS

HOW TO AVOID INHERITANCE TAX ON PENSION DEATH BENEFITS

Many TSR readers will have accumulated tax-favoured pension savings or will be contemplating doing so in the future. One area which is often overlooked is the issue of tax on the payment of any lump sums that could be payable either before or after taking benefits. This article explains the main issues to watch out for and a couple of possible solutions.

The pension death benefit tax problem

Registered pension schemes are permitted to pay a lump-sum benefit on the death of a member prior to them taking any benefits before age 75, up to the lifetime allowance (currently £1.65m for the tax year 2008/09), and this will usually be free of inheritance tax (IHT). A higher amount may be payable if enhanced and/or primary protection applies to those with benefits prior to 6th April 2006. The problem is that if this lump sum were paid to the surviving spouse or another beneficiary, then, on his or her subsequent death, the pension assets would form part of his or her estate and as such be subject to IHT at 40% to the extent that this value exceeds the available nil-rate band(s).

At age 75, a pension scheme member will have to take pension benefits (if not already taken), and this can take the form of an annuity, an alternatively secured pension (ASP) or a scheme pension (i.e. pension payments from a money purchase pension fund based on actuarial calculations). With an ASP and scheme pension the ‘income’ is provided directly from the fund and there is therefore the possibility that residual assets may be available in the fund upon the member’s death. Under a scheme pension, payment of a lump-sum benefit to family members who are treated as a connected party will attract tax charges of up to 82%!

Under ASP, the 82% tax is paid regardless of who receives the lump-sum death payment, connected or not. The only way to avoid these tax charges is to leave the benefits on death to a charity. Confusingly, although this option is available under ASP, it is not under a scheme pension where any residuary fund will be subject to unauthorised-payment charges regardless of whether the remaining fund is left to a charity or not.

Using a ‘gifts from income’ flexible trust from age 75

If you do not need the benefits from your pension at age 75, you could draw on your fund by taking a pension commencement lump sum (PCLS), usually up to a maximum of 25% and tax-free and a residual income, whether that is by way of an annuity, ASP or scheme pension. In general terms a standard annuity will produce the lowest level of income of starting income compared to an ASP and scheme pension. A scheme pension will usually produce the highest level of income at later ages as it is based on actual age compared to ASP, which is based on age 75 rates regardless of your actual age and with an income stream that is capped at 90% of Government Actuarial Department (GAD) rates.

Once the pension lump sum has been taken, this could be gifted to a flexible trust that would allow access through ‘reversions’ created in the trust at outset. As long as you live for seven years, the gift will be outside of your estate while still providing you access to that capital through the reversions created at outset. The remaining surplus pension income could also then be gifted (after allowing for income tax at the appropriate rate) to another flexible trust, which would also allow you access through reversions of capital created at the outset.

Because the gifts are regular and from surplus income, they will normally be exempt from IHT and so should not soak up your available nil-rate band, which governs whether 20% tax is payable on gifts made to such trusts. Proper record-keeping is vital in terms of your personal representatives being able to take advantage of this exemption in the event of your death. Similarly, because the reversions of capital are created at the outset, this planning should not fall foul of the gift with reservation rules which would otherwise apply. While it is likely that there will still be a residual pension fund on your demise, which would be taxed at up to 82%, the overall composite rate of tax payables should be far less with this strategy as opposed to doing nothing.

Using a benefit preservation trust before taking benefits at age 75

A ‘benefit preservation’ trust is typically a discretionary trust that is established by a member of an occupational or personal pension scheme during their lifetime, to receive his or her pension scheme death benefits (being the lump-sum benefits payable on the member’s death before pension benefits have commenced or during a period of annuity deferral).
The advantages of arranging for the pension death benefits to be paid into a benefit preservation trust are:

Your surviving spouse and family will have greater control over the use of any pension scheme death benefits.
Your family will avoid IHT becoming payable on the death benefits at the rate of 40% on the subsequent death of your spouse.

You can arrange for pension scheme death benefits to be paid into the benefit preservation trust by sending a letter (known as a ‘letter of wishes’) to your pension scheme administrator or pension trustees (as appropriate) during your lifetime, requesting that they exercise their discretion to pay any pension death benefits to your benefit preservation trust (which you would have already established separately – see below). The letter will not legally bind them to make such a payment, but it is likely they would follow your wishes.

Establishing a benefit preservation trust

There are two stages:

Establish a benefit preservation trust during your lifetime.
Send an expression of wishes to your pension scheme administrator regarding the payment of the pension death benefit to your benefit preservation trust.

The trust

The benefit preservation trust is established with an initial nominal sum, for example £10. If you wish to carry out IHT planning during your lifetime, you should establish a separate trust after establishing the benefit preservation trust, to avoid later tax complications on the benefit preservation trust.

Once the benefit preservation trust is established by the transfer of the nominal sum to the trustees, payment of the death benefits can be made by the scheme administrator or trustees of the pension scheme, if they are happy that they can do so.

The beneficiaries of the benefit preservation trust would normally be your surviving spouse, children and grandchildren etc. It is important that your surviving spouse is included in their capacity as widow or widower and not included in their capacity as your spouse, as this could cause unnecessary tax complications. Given that it is not intended that assets should be transferred to this trust before the death of the settlor, this should not, however, present any practical difficulties.

The trustees have the power to lend funds, interest-free, to a beneficiary. On the basis that the beneficiary spends those loans, this may give rise to an IHT-planning opportunity (subject to certain conditions) to create debts for IHT purposes on the estate of, say, your surviving spouse to whom an interest-free loan has been made.

A minimum of two trustees is required to make an appointment of benefits or to exercise a power under the trust (e.g. grant an interest-free loan to a beneficiary) where the appointment is in favour of a beneficiary who is also a trustee. This is to avoid any potential conflict of interest that could arise. Trustees also have wide powers to invest the funds received by them in any appropriate asset and tax wrapper.

In order to give some direction to the trustees of the benefit preservation trust as to how the pension death benefits are to be applied, you would, as the settlor of the trust, leave a letter of wishes with the trustees. The letter can indicate to the trustees who you would like them to consider as the primary beneficiary under the trust. This would usually be your surviving spouse and it would be best to name him/her as, of course, he/she can only benefit in the capacity of widow/widower as appropriate. It is important to note that this letter of wishes is not binding on the trustees of the benefit preservation trust, and so it is vital that you appoint trustees you are confident are likely to act in accordance with it.

Letter of wishes to scheme administrator/trustees

After you have set up the benefit preservation trust, you will then need to send a non-binding letter of request to the trustees of the pension scheme or scheme administrator requesting that they pay any death benefits that may arise to the trustees of your benefit preservation trust. This assumes that you would like death benefits to be paid other than directly to your surviving spouse, dependants or other beneficiary(ies) under the scheme’s trust or rules.

It is important to note that neither the scheme administrator nor the pension trustees will be bound in any way by any such letter of request, but they would usually take it into account in making their decision as to how the pension death benefits are to be applied.

It may be considered appropriate to obtain an agreement in principle from the trustees/scheme administrator of the pension scheme that they would have no objection to making a payment to the trust. They may ask to see a copy of the benefit preservation trust to ensure that they have powers to make such a payment under the governing trust and rules of the pension scheme.

Operating the trust – tax

The payment of the death benefits to your benefit preservation trust by your pension scheme trustees/scheme administrator would not be subject to any IHT charges as long as the benefits were paid to your trustees broadly within two years of death. If your widow/widower is likely to need access to funds within the first two years, then it would be better for a sufficient amount of the death benefits to be paid directly to your spouse by the pension scheme trustees/scheme administrators, rather than all to the benefit preservation trust.

Taxation of the trust

Income tax and capital gains

Income and gains arising within the trust would be taxed at 40% (32.5% on dividends). However, the first £1,000 of income would be taxed at the basic rate and the trustees would benefit from an annual capital gains tax exemption of £4,600 (reduced by the number of other trusts you have created subject to a minimum exemption of £960).

IHT

The value of the trust and all the growth arising would be outside of the estate of your surviving spouse, but could be subject to a tax charge on every tenth anniversary of the trust’s creation (the periodic charge) and whenever capital is distributed (the exit charge).

The 10-yearly (or periodic) charge

A 10-yearly (or periodic) charge can arise on the trust. The first periodic charge will arise on the first 10-year anniversary of the settlor joining the pension scheme which occurs after death benefits have been paid. A periodic charge can arise every 10 years after that.

The amount that is charged to tax is based on the value of the trust fund immediately before the 10-year anniversary. If this amount, when added to the settlor’s cumulative total of chargeable transfers made in the seven years before he joined the pension scheme and adding in any related settlements and property that have already left the trust, does not exceed the nil-rate band at that time, there will be no IHT due. However, if this amount is more than the nil-rate band at that time, IHT will be payable at a maximum of 6% of the excess. If IHT does arise, it will frequently be charged at a much lower effective rate.

The exit charge

This charge arises when some or all of the trust property leaves the trust, for example when the trustees make an absolute appointment of benefits. It is normally calculated as a fraction of the effective rate of tax paid at the previous 10-year anniversary. The charge is measured by the amount of the loss to the trust. If the trustees pay the tax, the amount charged is increased to take account of that tax.

Where the exit charge occurs before the first 10-year anniversary, if the value of the trust fund when the trust was set up, plus the value of any related trusts and the total amount of the chargeable lifetime transfers made in the seven years before you joined the pension scheme, is less than the nil-rate band at that time, then there will be no exit charge. In general terms, if no IHT was paid when the trust was established, there will be no IHT charge on exits in the first 10 years.

Where an exit of trust property occurs after the first 10-year anniversary, it is the rate of IHT that was paid at the last 10-year anniversary which will form the basis for calculating the exit charge. If no IHT was paid at the last 10-year anniversary, no IHT should be paid on the exit of capital leaving the trust.

If further amounts over and above the death benefits (called ‘added property’) have been paid to the trust, the position is more complicated and it would be best for you to consult your financial adviser.

The importance of a correctly drafted benefit preservation trust

Under English law, there are limits on how long trustees can accumulate any trust income before having to distribute it to beneficiaries. Typically, the accumulation period is specified as 21 years from the creation of the trust. If the trust for this purpose is treated as having commenced when the member joined the pension scheme, which is likely, then that is when the 21-year period would begin; so, in theory, it may well expire before the individual dies. Thus, it would not be possible to accumulate income at all.

To overcome this potential problem the accumulation period chosen in the benefit preservation trust should be defined as 21 years from the date of the death of the settlor. This means that there is no power to accumulate any income during the lifetime of the settlor. It is for this reason that it is recommended that no assets, other than the initial nominal gift, are transferred to the trustees. The Law Commission has made proposals to abolish the restrictions on accumulations of income.

An example of the trust in action: Tom and Mary

Before planning

Tom dies before reaching retirement, leaving his estate of £1,400,000 to his wife, Mary. Her estate was already valued at £700,000 and now, as a result of the legacy, increases to £2.1 million. In addition, Tom is entitled to death-in-service benefits of £1.2 million under his pension scheme and his trustees pay the entire amount to Mary, whose overall estate now increases to £3.3m.

On Mary’s subsequent death (assuming that she does not remarry and leave assets to a new surviving spouse), based on current tax rates and values and assuming that she spends £400,000 before death, the IHT liability arising will be £910,400, leaving an amount of £1,989,600 available to her children. This is on the basis that Mary’s personal representatives claim Tom’s unused nil-rate band.

After planning

When Tom died, the trustees made the payment of death benefits to Mary knowing that, because of the value of her estate (largely property in the shape of the private residence yielding no income), she would need liquidity and income.

If, instead, they had made the payment directly to the trustees of the benefit preservation trust, Mary’s estate (after receiving the legacy from Tom) would then have been only £2,100,000, as illustrated below.

If the trustees of the benefit preservation trust (of which there must be at least two) made interest-free loans to Mary of, in total, £400,000 and this (rather than other assets owned by her) was spent before her death, her taxable estate on death, taking account of the outstanding loan, would be £1,700,000. The liability to IHT would be £430,400, leaving, for the benefit of her children, a net estate of £1,269,600 and £1,200,000 under the benefit preservation trust: a total of £2,469,600. A tax saving and thus improvement in funds available to the beneficiaries of £480,000 has been secured.

Jason Butler is a Chartered Financial Planner and Investment Manager at City-based Bloomsbury Financial Planning. He has twenty years’ experience in advising successful individuals and their families on wealth-management strategies. Jason can be contacted by email: jasonbutler@bloomsburyfp.co.uk or telephone: 020 7194 7830.