How retirement changes bring estate planning opportunities

Julie Hutchison looks at how the changing retirement landscape affects estate planning

There have been some welcome changes in the area of pension death benefits and inheritance tax (IHT). The IHT uncertainty for those deferring taking their benefits has now gone, as has the complexity of the IHT charge on alternatively secured pensions (ASP). The new drawdown death benefit rules also present a fresh opportunity to cascade pension funds to future generations.

The omission to act rules will no longer apply to pension benefits, for clients who die after 6th April 2011. This means IHT will no longer be charged on those estates where the deceased had deferred taking income or reduced the income levels while in ill-health. Unfortunately, the old rules will still apply where the client died before 6th April 2011.

However, there are still some situations where IHT could arise for those in serious ill-health, e.g. making contributions and transferring pension benefits. Here HMRC's view is that there has been a transfer of value for IHT when the contribution or transfer is made. Where someone is likely to survive to enjoy their retirement, these will have a negligible value. But where death occurs within two years, the value will be much greater and IHT may be due.

Prior to 6th April, the combination of charges and IHT in ASP resulted in a potential tax charge of 82%. This led many providers to only offer charitable lump sum death benefits (LSDB).

Increased options
The abolition of ASP opens up LSDB options for the over 75s. Drawdown funds can now be distributed with a 55% tax charge on death at any age. This is an increase from 35% for death in drawdown before 75 under the old rules. However, mortality tables suggest that a male going into drawdown at 55 is likely to survive beyond their 80th birthday. This means for most individuals in drawdown, the new rules are much more favourable. Funds which may have previously been paid to charity will now be available to family members. This opens up the estate planning options for pensions.

Where there is a surviving spouse there is still a decision to be made whether to take a LSDB or to continue in drawdown. Taking a spouse's drawdown will delay the 55% charge until the second death.

There are other considerations which may influence the decision over the payment of death benefits. The final destination of the residual death benefits for the spouse's drawdown fund will rest with the widow(er). This may be a concern for the original spouse particularly where there may be children from previous marriages.
What if the surviving spouse loses capacity and does not have a suitable power of attorney in place? Or what if they meet a new partner and decide to leave everything to them? Is this what the first spouse would really have wanted?
Where the LSDB is paid to a bypass trust on first death, none of these negative outcomes arise as the trustees are in control of the funds.
A bypass trust is simply a discretionary trust, typically set up during an individual's lifetime, to receive any future LSDB. It is of course a vital step to check that the pension scheme rules allow payment of a lump sum to a trust.

Using a bypass trust is an effective way of controlling who will benefit from any LSDB. Asset protection, flexibility and IHT outcomes are all possible benefits, as well as an element of "control beyond the grave".

If the surviving spouse opts for a lump sum, it may well remain in the widow(er)'s estate on death. As a result, on their subsequent death, it could be subject to 40% IHT depending on the available nil-rate band. This does not happen where funds are retained in a bypass trust.

Trustees may be able to make loans to a beneficiary. Legal advice should be taken to ensure the loan is correctly documented. The benefit here is that the loan could be a deduction from the beneficiary's estate. Care would be needed where the surviving spouse had made third party contributions to the deceased's pension. It is possible in such cases that the loan would not be deductible for IHT.

The world of pensions and IHT remains a complex area. Careful planning is still needed to avoid potential pitfalls. One thing is for certain, however: it is now more important that ever to understand the estate planning possibilities of a pension.

Julie Hutchison is estate planning specialist at Standard Life