In a surprise announcement at the Conservative party conference on 29 September, George Osborne has revealed the government’s policy proposals on one of the most significant outstanding issues arising from the 2014 budget reforms: the taxation of “unused” defined contribution (DC) pension pots on death.
Full details of the proposals have yet to be made public by HM Treasury. However, the changes already announced – which include a complete scrapping of all tax charges where a member in flexible drawdown dies before age 75 – may well have a significant impact on member choices at retirement. As such, trustees and sponsoring employers of DC arrangements need to get to grips with the proposals and their potential implications.
Under the current tax regime, a special 55% tax charge is levied on any lump sum paid out to dependants where a member dies after taking flexible drawdown from a DC pension arrangement.
The same charge also applies where a lump sum is paid out from an untouched DC pension pot following the death of a member when aged 75 or more (known as an “uncrystallised funds” lump sum death benefit).
In either case, if a pension benefit is paid out to the member’s dependants instead of a lump sum, the amount paid is treated as pension income and is taxed at the recipient’s marginal rate (regardless of the age at which the member died).
The 55% tax charge has attracted widespread criticism as being too high, and therefore penal in its effects. It is significantly higher than the inheritance tax rate of 40%; and moreover, it applies to any lump sum paid, even if there is no inheritance tax to pay on the rest of the member’s estate.
In its July 2014 response to the ‘Freedom and choice’ consultation on the pension taxation reforms announced in the March 2014 budget, the government acknowledged that the 55% rate was too high. However, it said that it needed more time to consider how best to revise the current rules, since this was “a complex area”. The response further noted that “any changes have the potential for unforeseen and unintended consequences”, and promised to confirm the new policy in the Autumn Statement (not due till 3 December).
The proposals – death before 75
Many commentators had been expecting that the 55% lump sum tax rate would simply be aligned with the inheritance tax rate.
Instead, in another unexpectedly radical move, the Chancellor announced that from April 2015, all tax charges other than the lifetime allowance charge will be dropped where a member dies before 75 leaving an untouched DC pot or the balance of a flexible drawdown fund. The one condition is that the monies must be paid out to the member’s nominated beneficiaries either as lump sums or, if taken as pension, through a new flexi-access drawdown arrangement.
This removes not only the current 55% tax charge payable on lump sums where a member dies before 75 after taking flexible drawdown, but also any income tax liability at the recipient’s marginal rate where a drawdown pension is paid to the member’s dependants.
However, any dependants’ pensions paid from an annuity, or in the form of a scheme pension under an occupational arrangement, will not qualify for this favourable tax treatment. These will continue to be taxed at the recipient’s marginal rate, as under the current system.
HM Treasury has separately confirmed that lump sums payable from “value protected” annuities – where the member has paid for a guarantee that will ensure payment of a lump sum if he dies without receiving benefits equal to the full value of his pension fund (or a selected percentage of that fund) – will also benefit from the scrapping of the tax charge.
The proposals – death at or after 75
In relation to death at or after 75, the changes are more modest. The only immediate change is that the special tax charge rate for lump sums on unused pots will come down from 55% to 45% for the tax year 2015-16, though the government has said that it intends that from 2016-17 onwards, such lump sums will be taxable at the recipient’s marginal rate. Again, it appears that the same rules will apply where lump sums are payable from “value protected” annuities.
There are no changes proposed to taxation of pension benefits payable to dependants on the death of a member aged 75 or over. These will continue to be taxable at the recipient’s marginal rate, whether paid as scheme pension, a dependant’s annuity, or through a flexi-access drawdown arrangement.
What about defined benefit schemes?
An obvious question prompted by these changes is whether the same treatment will be applied to benefits payable from a defined benefit (DB) scheme. Under the current regime, the 55% tax charge applies also to a lump sum payable on death on or after 75 of a member with a DB pension entitlement.
Although not part of the Chancellor’s initial announcement, we understand that HM Treasury has confirmed that such DB lump sums will also benefit from the reduction in the tax rate, first to 45% and then to the recipient’s marginal rate. However, dependants’ pensions paid from a DB scheme will still be taxed in the same way as at present, both on death before and after 75.
When do the changes take effect?
George Osborne’s comment that the changes would benefit savers and their dependants “immediately” caused some initial confusion in this respect. Subsequent clarification by HM Treasury has confirmed that, although the tax changes only apply in respect of payments made after 5 April 2015, they will apply regardless of whether the member died before that date.
So if lump sum payments which could be made immediately are instead deferred until the next tax year, the beneficiaries may make a substantial tax saving.
Similarly, where a dependant’s drawdown pension is already being paid in relation to a member who died before age 75, no tax will be due on any instalments of pension which are paid from 6 April 2015 onwards.
With some commentators heralding this change as ‘another nail in the coffin of annuities’, it is clear that the new rules will add significantly to the attraction of drawdown arrangements as against annuities. Trustees and sponsoring employers of schemes providing DC benefits are therefore likely to come under increasing pressure from members to offer easy access to the new flexi-access drawdown benefit option, whether through the scheme itself or through streamlined transfer processes enabling a smooth transition into an appropriate arrangement at retirement.
The change could also provide an additional incentive for those entering retirement to take drawdown instead of taking all their benefits as a cash lump sum (under the new flexibilities to be introduced from April 2015). Any unspent monies which have already been withdrawn from a pension as cash will form part of the member’s estate on death and so will potentially be subject to inheritance tax, whereas unspent funds in a drawdown vehicle may escape tax altogether, or will only attract marginal rate tax. This is likely to be a material consideration for savers with larger pension pots, in particular.
Less obviously, DB pension members in ill-health who have a materially shortened life expectancy may be attracted by the proposition of converting their benefits into a transfer value and moving into a flexi-access drawdown arrangement on retirement. Through this route, members without a spouse or children eligible to receive any pension death benefits provided under their DB scheme would be able to unlock the value of those contingent benefits and pass it on to their preferred beneficiaries, either tax-free or at the recipient’s marginal rate. Again, trustees of DB schemes need to be ready to respond to such requests – particularly if made after the member’s normal pension age, when the statutory right to transfer out has been lost.
More immediately, any trustees or providers who are in the process of dealing with payments in respect of a member who has already died will need to take account of the implications of the timing of any payments. Deferring payment may well be advantageous for the recipient.
Finally, it has also been noted by observers with a more ghoulish sense of humour that the new rules provide a considerable incentive for relatives to hasten the demise of a member with a sizeable DC pension pot, so that it occurs before age 75. On that particular point, we must decline to comment further!