Using your pension fund to save paying IHT
A new pension regime came into force from 6 April 2015 that allows over-55s access to their pension cash and offers the opportunity of passing on pension assets to family members. Long-term, then, how could your pension start working for you and your family?
The freedom to pass on pension assets outside your estate for inheritance tax (IHT) purposes is of interest for tax planning purposes, not least because the ability to pass on tax-free cash is seen by some to be the start of families using pensions as "multi-generational ‘trust funds’".
A reminder about the limits of your Pension Allowance
First, your tax allowance relates to your earnings in any tax year and there is an annual cap on pension contributions of £40,000. However, as you can roll three years’ allowances together, it may be as well to look at whether you’ve used up all of your annual allowance, and if not and you are able, to claw back any allowance you haven’t used.
From April 2016, the threshold on pension assets must not exceed £1 million, but this limit applies to the value of the savings, not how much you put in. Pension savings over the limit will be taxed at 55% on withdrawal, so you should keep an eye on your pension savings and not risk going over the threshold.
As ever, a cautious approach is probably best
While these new rules present the opportunity to pass on pensions to loved ones potentially tax-free, beware, because HMRC is watching out for people it believes are exploiting the system. While pension pots normally fall out of the scope of IHT, they do incur a "death tax" under death benefit rules, which has been set at 55%.
Pension inheritance under the new rules:
- If you die before you take anything from your pension, it will usually be paid as a lump sum to your beneficiaries tax-free.
- As long as it is less than the lifetime allowance of £1.25 million in tax year 2015/16, it will be paid tax-free, unless you die age 75 or older.
- But the government has announced changes to the way death benefits from pensions are taxed:
- Death before age 75 – the pension can be paid to beneficiaries tax-free, either as a lump sum, an annuity, or through flexible drawdown. If opting for a lump sum, the money may be taxed if the beneficiary doesn’t use the money within two years of the pension owner’s death.
- If the pension scheme member dies at age 75 or over, the beneficiaries will only have to pay their marginal income tax rate when they take drawdown income. Alternatively, if a lump sum is paid, a 45% charge will be applied for a transitional period in tax year 2015/16 and thereafter (although legislation may change), benefits may be taxed at the beneficiary’s rate of tax.
As there are different rules depending on whether the pension holder dies before aged 75 or at 75 or older and whether the pension pot has been touched or not—that is, if the pension has been left to grow tax free—the tax implications are relevant for the pension holder as well as for the beneficiary. This is why it might mean, then, that many people will aim to leave their pension intact for their future beneficiaries. However, HMRC says it will be looking closely at people who, in a manner of speaking, strip themselves of their own assets in order to boost their pension pots. So watch out, be sensible, and get advice.
One expert has warned, "under the ‘disposition of assets’ rules, HMRC can levy IHT if it believes individuals are using pensions to shelter money. It is tempting to do it but the Revenue has power when someone dies, and their affairs are disclosed, to issue a disposition of assets …. They will say you have got rid of money out of [your] estate to avoid IHT and then they can still treat [the pension] as if the money was still there [in the estate] … you could open yourself up to a legal challenge." Other experts warn that the rules could change again by the end of the decade. With that in mind, maybe it’s a case of working cautiously within the rules, not putting all one’s eggs in one basket, but maximising one’s benefits, allowances, and assets much as we have been doing up until now.
Commercial property and investments
Visit the DNS website to read about how commercial property such as an office or warehouse can be held as part of a pension fund and to get some ideas for other pension-friendly investments and inheritance-tax free incentives.
Why are pensions better than ISAs?
It is worth pausing for a moment to ask whether pensions are a better deal than ISAs. It is as well to point out that the £8,000 in an ISA, if paid into a pension, would see £10,000 invested on your behalf. Your pension attracts tax relief, twice: any contributions to your pension attract tax relief on the way in and accumulate income and gains tax-free once inside. Higher rate taxpayers could claim a further 20 percent relief via their tax return. On the other hand, you have your tax-free ISA allowance, so maybe it should still be a deliberate investment choice alongside your pension allowance. Read more on the comparison on our website.
It is important to keep your total other assets below the current IHT threshold of £325,000 (£650,000 per married couple).
Bear in mind that while you are allowed to hold commercial property as part of your pension fund you cannot buy residential property. Still, a buy-to-let will earn additional income and might be a good investment alongside your pension.
Use your annual £3,000 gift exemption each year. Above this, you need to survive seven years for the gift to fall entirely outside of your estate for death tax purposes.
Writing a will
Finally, the importance of writing a clear, concise, correct will, in which all the names of beneficiaries are spelt correctly, cannot be overstated. Alongside your will, pension assets will be distributed by the trustees of the scheme and so it is vital to provide them with a "letter of wishes" that you should revise frequently alongside your will.
What you should do?
How you manage your wealth and assets is a task that needs long-term planning. DNS is expert in this area: we can advise you on tax planning, put you in touch with strategic partners, and ensure that the plan you have in place is maximising the benefits for you and your family in the long term. Please get in touch with one of the team today to look at how to go forward in the new tax year.