Since the abolition of the 55% pension “death tax” pensions have become a much more useful inheritance tax tool than previously.
In summary, pensions can now be passed on tax free if someone dies before age 75. If they die after reaching 75, there will be tax payable, but not as much as before, and the beneficiaries do have more options.
To illustrate, George and Ed have houses of identical value which use up the nil rate band (including the nil rate band passing on first death), but George has £500,000 invested in a pension whereas Ed has £500,000 in stocks and shares managed by a stockbroker. Both die aged 74 – George’s estate pays no IHT but Ed’s estate pays £200,000. George’s beneficiaries can take either take the whole pension fund as a lump sum or draw a tax free income from it.
If George and Ed are 75 rather than 74 years old when they die, the beneficiaries have three options:
1. Take the lump sum in one go and pay tax at 45% (this will be reduced to each beneficiary’s marginal rate from 6th April 2016).
2. Take a regular income and pay tax at their marginal rates.
3. Take periodical lump sums, which will be treated as income and taxed at their marginal rates.
Unlike Ed’s beneficiaries, who have no choice but to pay inheritance tax, George’s beneficiaries can control the tax they pay by planning their withdrawals efficiently.
It is of course important to make a will clarifying who your beneficiaries are!
Given the tax reliefs available for making pension contributions in the first place, whether personally or via your owner managed company, pensions can be a win-win for you and your family.
There is another way in which pension contributions themselves can reduce Inheritance Tax. It is possible to make pension contributions to registered pension schemes on behalf of your children and grandchildren, of at least £3,600 per year per individual recipient. Where the child has earnings from employment or self employment the possibilities can be much greater. Using the carry forward rules a contribution of up to £180,000 could be made if the child’s earnings are high enough. This would not only be a potentially exempt transfer for inheritance tax, but the child would also benefit from the 25% government top-up of the contribution. If they are a higher rate taxpayer they will benefit from further tax relief, and of course the income and capital growth within the fund is tax free. If you look at the tax savings across the whole family, in certain circumstances these could be spectacular. There is also a practical benefit in that your son or daughter may be finding it difficult to make their own pension contributions because they are at a time of life where they have heavy commitments such us children of their own or a large mortgage. Where the child is under 16, the pension plan will have to be set up by the parent or other legal guardian on behalf of the beneficiary, but there is no minimum age limit.
Businessmen know that the tax tail should never wag the commercial dog – and this is the perfect example of tax efficient planning meeting real family needs rather than wagging the family dog!