The freedom to take all your pension as cash on retirement has made the headlines, but the government’s scrapping of the so-called pension ‘death tax’ could have an equally dramatic effect once the implications are more widely appreciated. The so-called ‘death tax’ is the tax levied on pension funds at death.
The magic number is always 75 !
Under the old regime a person who died before their 75th birthday and who had not accessed their pension could pass it on as a tax-free lump sum to a spouse. If a pension was paid out to a spouse or dependent child under the age of 23 as income it was taxed as such. If the same person had accessed their pension before they died then lump sums were passed on to a spouse but only after a 55% death tax, with any income taxed as such. Where a person died after their 75th birthday the pension could be passed to a spouse or dependent child under age 23 but only after the 55% death charge, whether the pension had been accessed or not.
Under the new regime, if a person dies before age 75 the pension can be passed on tax free to anyone whether it has been accessed or not. If the person dies after their 75th birthday, the remaining pension pot can be passed on to anyone but only after a 45% tax charge … which in the 2016/2017 tax year will change to the beneficiary’s marginal rate of income tax rate.
These changes are likely to encourage more people to put more money in their pensions and, perhaps more interestingly, change the manner in which they plan their income in retirement. Under the new regime it may make more sense for retirees to use up the savings they have outside of pensions because of the new opportunities for ‘generational tax planning’. Where inheritance tax is a concern and where they have a choice, people will tend not draw from their pension fund but instead get tax their income from other assets.
The new regime effectively allows pension holders much greater freedom to pass on funds to their children, and not just their spouse. For this reason, it would not be a surprise if a future government subsequently restricted some of these freedoms, especially as children could gain access to any tax-free money straight away as things stand. It would make much more sense to allow people to pass their pensions to their children providing that the recipient could not access the pension until they themselves retire. It is not difficult to anticipate a tightening of the regime in the near future.
Given the significant scope for inheritance tax mitigation contained within the new regime it would be wise to caveat any planning with the possibility of ‘regime change’.