To some surprise, major changes to the tax treatment of pensions when left to another on death were announced by George Osborne MP, the Chancellor of the Exchequer, at the recent Conservative Party conference.

Currently, a tax of 55% applies to anything that remains in a pension pot left to another person on death. This so-called “Death tax” is only exempt if the deceased is over 75 years old at the time of death and if his/her pension is left to a spouse or dependent under 23 years of age, who will subsequently pay income tax at their own marginal rate when they draw down the pension.

What the changes will mean in practice?

From April 6 2015, all inherited pension pots will be free of tax if they are kept as pension savings. Under the Chancellor’s plans:

  • If someone aged 75 or over dies while drawing down their pension, the beneficiaries will only have to pay their marginal income tax rate on the handed down pension pot income;
  • If someone dies aged under 75, their pension pot can be left tax-free to any beneficiary they have nominated, even if the pension is already in drawdown. The beneficiary will not have to pay any income tax on their drawdown pension income.

The changes, if implemented, will only apply to “income-drawdown” pension funds and “value-protected” annuities. The reforms will therefore not apply to final salary or defined benefit pensions or annuities. Lump-sum withdrawals from pension pots will also continue to be taxed at the beneficiary’s marginal income tax rate under the plans.

Importantly, the reforms will affect payments made on or after 6 April 2015, rather than deaths on or after 6 April 2015. Thus, the beneficiaries of an individual who dies with an entrusted pension pot before the changes take effect can still benefit, so long as payments from the pension are delayed until on or after 6 April 2015. Beneficiaries should, where necessary, ask their pension scheme administrator to delay payments in order to benefit from the change.

Opportunities for better inheritance tax and estate planning

Subject to the Chancellor’s plans being realised, which is likely to be confirmed in the Autumn Statement on 3 December, the changes will give individuals more scope for long-term financial planning. In particular, the changes may allow for better inheritance tax and estate planning. For estates worth over the inheritance tax nil-rate band of £325,000, it may prove worthwhile to transfer assets to a pension pot up to the lifetime allowance of £1.25 million. Individuals should also review their Wills and trust provisions as part of their overall financial planning in light of the proposed changes.