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Ahead of the Autumn Statement in December, the government has announced the implementation of some interesting changes to the rules surrounding the taxation of defined contribution pension funds. These are due to take effect from 6 April 2015.
Elimination of ‘55% death tax’
Firstly the amount of tax payable if a person inherits a pension has reduced significantly.
Anyone inheriting a pension currently incurs a tax charge of up to 55%; with only spouses and financially dependent children under the age of 23 being exempt from the charge, and instead being able to withdraw the pension at their usual rate of income tax.
With effect from 6 April 2015, two more tax efficient scenarios will apply depending on the age of the deceased:
- If the holder of the pension is aged under 75 on death, they are able to pass their remaining defined contribution pension to anyone as a lump sum completely tax free, provided an annuity has not been purchased;
- Anyone who dies with a drawdown arrangement over the age of 75 can nominate a beneficiary who will be able to access the pension funds flexibly at any age and pay tax at their rate of income tax. So a lower rate taxpayer will pay 20%; a higher rate taxpayer 40% or 45%.
Clearly this is a change designed to encourage pension contributions at a time when other restrictions to pensions tax relief have been imposed. It places the inheritor in either a better position than the original pension holder, or in the same position – paying tax at the same rate as they would on other income, which certainly seems a lot fairer. In addition, a saver can now bequeath a pension knowing the beneficiary won’t have to worry about penal tax charges.
For older wealthy taxpayers in particular, this could make simply giving assets away early to avoid the inheritance tax liability less attractive. If the pension investor is still earning, they will continue to receive up to 45% tax relief on pension contributions, to a maximum of £40,000 each year. So as a worst case scenario, anyone inheriting the pension pot will pay up to 45% tax on the income, creating an equalizing effect. For a large portion of taxpayers, the tax rates will be significantly lower.
Multiple withdrawals are tax free
The second change introduced to the tax treatment of pensions positively impacts the saver. It is already no longer necessary to purchase an annuity for 75% of the fund’s value and it is already possible for pension holders to use their entire fund like a savings account. Under the current rules, once an investor reaches age 55, they are able to make a single tax free withdrawal of 25% of the fund value and thereafter, will incur tax at their marginal rate on the remainder of the fund as it is taken as a pension. The new rules will provide an opportunity to make multiple withdrawals, with each offering 25% of the amount withdrawn tax free. Pension companies have said this will be extremely difficult to operate as pension funds are not set up in the same way as banks, so it will be interesting to see how this idea develops.
Inheritance tax remains an important issue
Money bequeathed from a pension fund is exempt from inheritance tax, however in order to take advantage of this exemption it is important to ‘tick the right box’ to determine who will inherit your pension pot. Many investors don’t understand the implications when completing the paperwork and inadvertently leave their pension fund within their estate on death rather than bequeathing it on trust for someone else. Where a pension fund falls within someone’s estate on death it is liable to inheritance tax, whereas no inheritance tax applies when it is bequeathed.
Arranging a pension which is exempt from inheritance tax, coupled with the scrapping of the 55% tax charge, results in an extremely tax efficient way for pension rich individuals to pass assets to their heirs free of tax.
However when considering inheritance tax, the fact remains that for most taxpayers, the majority of their liability arises from property assets, such as the family home. With property prices continuing to rise, there is still a need to increase the inheritance tax threshold. Rumour has it an announcement will come in spring 2015, or will there be something in the 2014 Autumn Statement? We will have to watch this space to see and I’ll be blogging over the coming weeks about what’s likely to be announced in December.
If you would like to discuss pensions taxes, inheritance tax planning or any matter relating to probate, please contact Lesley Stalker by emailing las@rjp.co.uk.
