Your guide to death benefits, IHT & by-pass trusts

Neil MacGillivray of James Hay Partnership explains how to advise on the new pension legislation in the most tax efficient way.

This year has seen yet more major changes to pension legislation. With the removal of the requirement to annuitise at age 75, along with the introduction of capped and flexible drawdown, it is essential advisers are fully aware of the consequences of these changes.

The new added flexibility on how pension benefits can be taken will attract many more individuals towards choosing drawdown and the need for advice on how best to extract those benefits in the most tax effective manner will be essential. Now that the drafting of the new legislation is almost finalised, it is an opportune time to review how the changes impact on lump sum death benefits, their tax implications and if there is still a place for by-pass trust arrangements.

One key thing that is not changing is that lump sum death benefits payable from pension funds that have not been crystallised will continue to be Inheritance Tax (IHT) free where the member dies before attaining the age of 75. However, it also means that should the benefit be paid directly to a beneficiary, it will form part of the beneficiary’s estate and is potentially just a deferral of IHT.

Therefore, the benefit of creating a by-pass trust where, on the member’s death, the lump sum death benefits pass to the trust and not directly to the beneficiary, continues to be an attractive option. The beneficiary still has full access to the death benefits either in the form of income, capital payments or loans, but with the advantage that the funds remaining in the trust at the time of the beneficiary’s death will not be included as part of their estate for IHT. A simple example is given.

Example one

Mrs Brown has an estate worth £850,000 which includes a £200,000 lump sum death benefit from her husband’s pension fund. If the £200,000 had been paid to a by-pass trust, on Mr Brown’s death, it would not form part of her estate and potentially save £80,000 in inheritance tax. Mrs Brown would be able to benefit from the funds held in trust during her lifetime as and when required.

Where the member dies before attaining 75 having crystallised their benefits, or dies after attaining 75, without crystallising their benefits, the lump sum death benefits will be subject to a 55% recovery charge. Additionally, if the net benefit is paid to the spouse, it will form part of the spouse’s estate and on their death may then also be subject to IHT. This could mean a potential total tax charge of 73%. The option of using a by-pass trust may again be attractive.

The ability to retain pension funds in a low tax environment, along with the control of when the pension commencement lump sums and pension income can be taken, means a member could leave their pension uncrystallised until aged 75 and instead run down other assets to provide an ‘income’.

Where a member does require access to their pension prior to attaining 75, phased drawdown may be an alternative option to consider. The facility to take pension commencement lump sums in tranches under phased drawdown has always been attractive, and under the new rules if the member dies prior to 75 they could have their uncrystallised benefits paid to a by-pass trust and their crystallised benefits used to provide a dependant’s pension, thereby deferring the 55% recovery charge, which can only add further to its attraction. This is covered in example two.