Cushioning the blow of IHT

Matthew Stephens discusses how recent changes brought in by the Finance Act can bring estate planning benefits and lessen the impact of inheritance tax.

The Finance Act 2011 confirms that “where a… member of a registered pension scheme… omits to exercise pension rights under the… scheme, section 3(3)… does not ­apply in relation to the ­omission.”

The reference is to section 3(3) of the Inheritance Tax (IHT) Act 1984, which provides that IHT charges ­apply where an ‘omission’ takes place.

In relation to pensions, the ‘omission’ is a deliberate failure to take benefits at a time when the member is able to.

In such circumstances, IHT could be levied on the value of the pension benefits that have not been taken.

It is the value of the right to a lump sum and annuity that is potentially liable to IHT, not the value of the pension fund itself.

This legislation was tested, and IHT confirmed to apply, in the Fryer case (Fryer & Ors v HMRC [2010] UKFTT 87).

The Finance Act has effectively reversed this position, while also ­increasing the tax charge on lump sum death benefits paid from ­income drawdown to 55%, and ­applying it to lump sums on death after age 75. This raises interesting estate ­planning opportunities.

IHT does not apply to lump sum death benefits paid from pension schemes where the member has not taken a lump sum and/or ­income.

For example, a return of fund ­under a personal pension, provided that the scheme trustees/administrators have discretion over who the lump sum is paid to. Such discretion ­applies to most schemes.

Reaping IHT-free rewards

As deferring taking ­pension ­benefits will not incur an IHT charge, it is possible to use ­non-pension money or assets to help ­supplement income up to age 75.

­Using ­assets subject to IHT in this way will ­reduce the IHT effects.

Take, for example, someone aged 60 with assets subject to IHT of £600,000 above the nil rate band and £450,000 in a personal pension.

Using the entire pension fund to provide a lump sum and income does not reduce the estate, so IHT of £240,000 would be payable on death (i.e. £600,000 x 40%). ­

Assuming any tax-free lump sum from the ­pension is spent, the amount over the ­nil-rate band available for ­beneficiaries would be £360,000.

The pension could also pay out money, depending on the form in which income was taken.

For ­example, if the residual fund ­after 25% cash was used for income ­drawdown, that residue (after 55% tax) could be paid out as a lump sum on death.

But what if part of the pension fund was deferred, with some of the ­estate used to supplement income?