Tax treatment of death benefits for drawdown..
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For many years clients in drawdown have known that on their death there would be a significant tax charge on any lump sums paid to their beneficiaries. From April this year the tax is being abolished for many and reduced for others.
How it was
Lump sums on death in drawdown were taxed at 35% up to 2011, when George Osborne increased the tax rate to 55%. This rate also applied to any lump sums arising from value protected annuities. Where a SIPP member reached age 75 with an ‘unvested’ pension this was deemed by HMRC to have crystallised and any lump sum death benefits paid after 75 were subject to the 55% charge.
Income payments on death in drawdown could only be paid to ‘dependants’, who were generally widow(er)s, as other family members only qualified if they were children in full time education or disabled children. The payments were taxed under PAYE at the dependant’s marginal rate of tax.
How it will be
It should be noted that the changes apply based not on the date of death but on the date of payment, so if a client died before April 6 2015 the new rules will apply for beneficiaries providing no payment is made until April 6.
• Lump sums on death below age 75, whether from drawdown or from unvested plans, will now be completely free of tax, as will income payments to any nominated beneficiary or their successor. And there is no restriction on who can be nominated as a beneficiary.
• If death occurs after 75 any lump sum will be subject to a 45% tax charge in tax year 2015/16 and thereafter would be taxed at the beneficiary’s marginal rate. For large funds at least part of the fund will be taxed at the additional rate of tax of 45%.
Where the fund is used to provide income to a beneficiary then this income will be taxed at their marginal rate. Payments could be made to several beneficiaries, perhaps using their personal allowance or 20% tax band.
If a beneficiary subsequently dies the tax status of any remaining payments will depend on whether they were under or over 75 at death: if a beneficiary who is receiving taxable income dies under 75 the remaining fund would become tax-free to their successors.
Under the current ‘how it was’ rules, there has been strong justification for clients to withdraw any remaining tax free cash left in their pension to avoid a potential 55% charge on death. Under the new ‘how it will be’ rules, the decision to take remaining tax-free cash is much less certain – with effective planning, withdrawals from the pension could be made tax-free or at a low marginal rate which could be more tax efficient than the beneficiaries owning the assets directly and possibly incurring tax unnecessarily.
The tax position of by-pass trusts is a little more complicated and we will deal with this in a later update.
John was 78 when he died in December 2014 and was married to Julie who was 68. John had £300,000 in a drawdown plan. If he nominated Julie to receive benefits she will be able to take a net lump sum of £165,000 after April 5th or she could take income from the plan, paying tax at her marginal rate. If she took the lump sum then this would be part of her estate on her death whether aged under 75 or over, and could be hit with another 40% Inheritance Tax charge.
If however Julie did not take a lump sum or any income from the plan, no tax would be payable. If Julie subsequently died before she was 75 her beneficiaries could receive the fund tax free.
If John had nominated his grand-children Lucy, 12, and Ben, 10, they could each take tax free income equal to their personal allowances of £10,600 (2015/16) throughout their education, and then take no further income until they retire in perhaps 50 years’ time. Lucy and Ben might use this income to pay for their education, thereby avoiding student loans completely. If Lucy or Ben took a career break, perhaps to start a family or further their education, they could again switch on the tax free income up to their personal allowance.
Of course the key question before nominating grandchildren is can Julie afford to live without any income from John’s plan? Unlike a by-pass trust she will not be able to borrow from the fund if she needs additional income, so the pension fund should be considered as a gift. As with any gifting it can be tax efficient but it needs to be affordable.
Clearly where someone has already died and benefits not paid out yet, it will usually make sense to wait until after April 5 to take account of the new rules.
It is very important that clients nominate the beneficiary for the funds to ensure they go to the people they want them to or they could end up being paid to the estate and being liable for inheritance tax.