Of universal interest is the unexpected announcement at the Conservative party conference on 29 September 2014, well ahead of the Autumn Statement, from George Osborne that from April 2015, individuals will have the freedom to pass on their unused defined contribution (DC) pension fund on death to any nominated beneficiary, rather than paying the 55 per cent tax charge which currently applies.

In addition, on 14 October 2014 to coincide with the publication of the Taxation of Pensions Bill, the Treasury highlighted the uncrystallised funds pension lump sum under which individuals over age 55, who are not in flexi-access drawdown, will be able to withdraw lump sums from DC pension funds. A quarter of each withdrawal will be tax-free, with the remainder taxed as normal pension income at the individual’s marginal rate.

Taxation of inherited pension funds

From 6 April 2015, for scheme members who die before age 75, there will be no tax charge on lump-sum death benefits paid from a drawdown pension or uncrystallised funds to a nominated beneficiary. The beneficiary will no longer need to be a dependant of the late member (that is, a spouse, civil partner, child under 23 or other financial dependant). As before though, lump sums passed on to a beneficiary will be tested against the deceased’s lifetime allowance (LTA), currently £1.25 million, with the excess being chargeable at 55 per cent. However, any pension wealth that a person inherits will not count towards his own LTA.

For scheme members who die on or after age 75, with either a drawdown fund or uncrystallised funds, these too may be passed on to any nominated beneficiary and the 55 per cent tax rate will no longer apply. Tax will be payable on lump sums from either crystallised or uncrystallised funds by the recipient at a rate of 45 per cent (reduced from 55 per cent) from 6 April 2015. From 2016/17, the Treasury intends to apply the recipient’s marginal-rate tax to lump sum payments in place of the 45 per cent rate, although the relevant legislation has not yet been published and will be subject to consultation before being finalised.

A summary of the changes

The current and future tax charges are summarised in the table below:

Click here to view table.

The proposed new tax concessions do not apply to income from annuities or scheme pensions, which will continue to be taxed at the beneficiary’s marginal rate.

Lump sum death benefits

The following lump sum death benefits will be tax free where the member dies before age 75, and taxed at 45 per cent (or marginal rate from April 2016/17) where the member dies at age 75 or above:

  • pension lump sum death benefit
  • annuity protection lump sum death benefit
  • drawdown pension fund lump sum death benefit
  • defined benefits lump sum death benefit
  • uncrystallised funds lump sum death benefit.

Deaths before April 2015

The changes will apply to payments made on or after 6 April 2015, rather than deaths on or after that date, so beneficiaries may wish to ask scheme administrators to delay payments until the new regime is in force. Beneficiaries of members whose death pre-dated the announcement on 29 September 2014 will also be able to benefit from this change. However, tax free lump sums (where the member died before age 75) must still be paid within two years of the scheme administrator being notified of the death.

The changes will apply to payments made on or after 6 April 2015, rather than deaths on or after that date, so beneficiaries may wish to ask scheme administrators to delay payments until the new regime is in force. Beneficiaries of members whose death pre-dated the announcement on 29 September 2014 will also be able to benefit from this change. However, tax free lump sums (where the member died before age 75) must still be paid within two years of the scheme administrator being notified of the death.

Uncrystallised funds pension lump sum (UFPLS)

A new type of lump sum, the uncrystallised funds pension lump sum (UFPLS), will be available from 6 April 2015. Individuals over age 55 (or younger, where the ill-health condition is met) will be able to withdraw a UFPLS directly from a DC scheme, without designating the funds for flexi-access drawdown. Income tax at the member’s marginal rate will be payable on 75 per cent of the withdrawal amount, with the remaining 25 per cent being tax free each time.

There is no limit to the amount that may be paid as a UFPLS, subject to the member having sufficient lifetime allowance. However, payment of an UFPLS on or after 6 April 2015 will trigger the new annual allowance of £10,000 for tax-free pension contributions.

A UFPLS is not available to certain individuals who enjoy enhanced or primary protection.

HMRC has issued new draft guidance on pensions flexibility, including the flexibility relating to death benefits.

View the draft guidance.

Comments

The Chancellor’s announcement on inherited pension funds took the industry by surprise, as the tax changes to unused DC pension pots on death were not expected to be disclosed fully until the Autumn Statement scheduled for 3 December 2014. The announcements could have significant impact on scheme members’ choices at retirement, as there will no longer be an incentive to dissipate pension savings in an attempt to avoid the former punitive tax rates which applied to unused pension funds on the member’s death.

However, members should be encouraged to complete their “expression of wish” forms to indicate to whom pension funds should be paid on death, and to ensure those nominations are kept up to date.

Where no such nomination has been made, and where there appears to be no obvious beneficiary to whom the payment could be made under discretionary trusts, scheme administrators may choose to pay the pension into the deceased’s estate as a lump sum. In these circumstances, the fund would be subject to a 45 per cent tax charge where the member was age 75 or over on death, before being paid to the estate. Where the member dies under age 75, the lump sum would be paid to the estate tax free, but in either case the member’s entire estate would be subject to inheritance tax if it exceeds the relevant tax threshold.

As regards the UFPLS facility, DC schemes will need to decide whether to allow their members to access their DC pots in this way, either through scheme amendments or by using the permissive statutory override. However, the potential complexity of some calculations, for example in relation to the pension input amounts in hybrid schemes, may deter some schemes from adopting the full range of flexibilities. In these circumstances, members would need to transfer their DC pension savings to another arrangement which offers the UFPLS form of pension fund access.