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Vets Update - Radical Changes to Pensions

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12 November 2014

You may have heard in the media that radical changes have been announced to the taxation of pensions. 

As accountants we are not able to provide investment advice and we consider below the tax impact only of the announced changes.  We do not exhaustively list the current rules here, rather focus on the key changes afoot.

In many cases, HMRC currently takes 55% of pensions pots in the form of tax upon death unless they are left to a husband or wife or a child under 23. 

In a move that the government have suggested could benefit hundreds of thousands of people each year, this 55% tax is being removed from 6 April 2015 (apart from where stated below). 

We have summarised the changes below, which include a distinction whether an individual dies before the age of 75 or when they are 75 or over.

It is worth first defining a couple of terms.  Draw down means withdrawals from a pension fund until there are no longer any remaining funds.  This is different to an annuity which coverts the funds in a pension fund into a form of fixed income for life.

How will the change affect those who die before the age of 75?

From 6 April 2015, anyone who inherits a pension fund from someone who dies before aged 75 will have no tax to pay when they receive it, whether or not the fund was already being drawn down on before death. 

Furthermore, there will be no tax payable by the individual when they draw down on a pension fund that they have inherited, subject to the £1.25m lifetime allowance.

To the extent the lifetime allowance is exceeded, there will be a 55% tax charge on lump sums, 25% on drawn downs and 25% on annuities received above the £1.25m.

How will the change affect those who die who are 75 or over?

The position is the same as when a pension fund is inherited from a person that dies who is under 75, with the exception that from 6 April 2015, the individual who inherits the pension fund will pay income tax at their marginal rate of tax when they drawn down or receive a lump sum from the fund (subject to the important transitional rules for lump sums – see separate section below on transitional rules).

Let’s illustrate this using some examples using 2014/15 tax rates and assuming a “normal” tax code 1000L, i.e. £10,000 of tax free personal allowance is available.

1. An individual with taxable income in the tax year of £45,000, i.e. who is a higher rate tax payer, who draws down or receives a lump sum of £30,000 in that same tax year, would pay income tax at 40%, i.e. £12,000.

2. An individual with taxable income in the tax year of £10,000, i.e. who is a basic rate tax payer, who draws down or receives a lump sum of £30,000 in that same tax year, would pay income tax at 20%, i.e. £6,000.

3. An individual with taxable income in the tax year of £30,000, who draws down or receives a lump sum of £30,000 in that same tax year which would take them out of basic rate tax and into higher rate tax, would pay some tax at 20% being £2,373 and some tax at 40% being £7,254, i.e. total income tax of £9,627.

What are the transitional rules to watch out for?

If the individual who inherits the pension fund from someone who is aged 75 or over chooses to receive it as a lump sum (but not as draw down or an annuity), an interim tax charge of 45% will apply from 6 April 2015. 

The government have indicated that from 6 April 2016, this transitional measure is likely to be abolished so that even a lump sum payment would be taxed at the marginal rate of tax, whatever the age of the individual who has died, although this is subject to their confirmation.

What about annuities?

Generally once an annuity is purchased, it cannot generally be passed on to someone else, other than a spouse, without incurring a cost. 

Annuities are taxed as income in the hands of the individual receiving the annuity payments.

What about inheritance tax?

Normally pensions do not form part of an individual’s estate in the event of death and are therefore not subject to inheritance tax, unless there is a binding right for the individual’s estate and/or its beneficiaries to receive a lump sum.  The new rules detailed above do not change this inheritance tax position.

It is quite common for a binding right not to exist, where the pension scheme trustees or provider has discretion as to how the pension is dealt with.  This is often the case where the individual who has died has left an expression of wishes detailing what they would prefer happens with their pension fund upon their death.

Summary

The table below summarises the new rules set out above:

From April 2015 Die Aged <75 Die Aged 75 or Over
Draw down Tax free Taxed as income
Lump sum Tax free Taxed as income (*)
Annuity Taxed as income Taxed as income

* Subject to the transitional rules detailed

If you have any specific questions on pensions or financial planning matters, then it would be worthwhile speaking with your financial advisor.