How can you ensure your beneficiaries receive the maximum benefit from your pension?

Pensions are attractive to many due to their tax-efficient nature. Tax relief is applied upon contributions, turning, for example, £80 into £100 in an instant, furthermore, higher and additional rate taxpayers can claim further tax savings in line with their marginal rates. Once invested, the growth in the pension will be free from personal income and Capital Gains Tax, and when the time comes to withdraw funds you can take up to 25% of the holding free from any tax.

Another attractive tax quality that pensions provide is that upon death, funds held in a pension are not included in valuing your estate. This means that when calculating Inheritance Tax (IHT), if this applies to your estate, your pension funds aren’t included and therefore won’t be subject to a 40% tax.

However, as with many aspects of financial planning, it isn’t always this straightforward as the following example highlights

A married couple with children own their £350,000 home outright, have a second property worth £150,0000, and savings and investments worth a further £300,000. This brings their combined estate value to £800,000.

Each individual has a nil rate band, of £325,000, which represents the value one’s estate can be before becoming liable for IHT. Furthermore, those who own their own property and leave it to their direct descendants, may benefit from the residence nil rate band (RNRB) of up to £175,000 per person.

This is the case for our example clients, who have wills and plan to leave their entire estate to their children. They therefore have combined allowances of £1m, and of course, their estate falls well within these allowances.

In addition to these aforementioned assets, they each hold defined contribution pensions which are both valued at £400,000. They’ve been diligent and completed nomination forms so that the upon their passing, the surviving spouse would receive the deceased’s pension.

All so far, so good.

However, an issue with significant IHT consequences could arise if they’ve failed to check as to how the death benefits are paid out. Pension schemes can do this in a couple of different ways:

• Paid out as a lump sum, or
• By way of a nominee flexi-access drawdown

Whilst legislation allows for either method, some providers and pension schemes do not. This means that they only have the ability to pay the proceeds out by way of a lump sum. This tends to be the case with those schemes that were in place prior to Pension Freedoms legislation being introduced in 2015.

If we look back at our couple. Following the death of the first spouse, their pension pays out a lump sum equal to the value of the pension holding, tax-free, to the surviving partner. The deceased made no use of their IHT allowances, which are inherited by the survivor and therefore their £1m IHT allowance is maintained. However, the survivor now has:

House £350,000

Rental Property £150,000

Savings and investments £700,000

Total £1,200,000

On the death of the second partner this then means 40% tax is due on the value of holdings above £1m and therefore the estate on the second death will face an £80,000 IHT bill (40% of the £200,000 over the £1m threshold). Like a lot of IHT, this could have been avoided had the couple reviewed the death benefits on their pension schemes and taken action to address this concern prior to the death of the first partner.

To understand the impact your death would have on the value of your pensions and to review how the proceeds would be passed on, please get in touch. Call 07590 205 918 or email stuart.smith@armstrongwatson.co.uk.