Following the Taxation of Pensions Act 2014 two new classes of beneficiary have been created which have inheritance and wealth planning implications. Within a drawdown fund benefits used to only be payable to a dependent upon death of the member but can now pass to nominees of the member and thereafter to successors of the nominee or dependant.
In this way pension funds in flexi-access drawdown can be passed from generation to generation until the funds are used up. Furthermore, if the member, dependant, nominee or successor is under age 75 when they die then the income will be paid tax-free to the new owner.
A Case study
Alex, a successful businessman, age 56, is married to Naomi with a dependent daughter, Emily. Alex wants to retire early and needs a gross annual income of £25,000. To facilitate this, Naomi, age 46, will carry on working until Alex’s state pension is payable in 10 years’ time. Alex has a house worth £1.5 million with no mortgage, a unit trust and ISA portfolio valued at £900,000 and a SIPP invested in collectives worth £600,000.
Alex would like to have a capital lump sum to fund a new sports car and pay for a world cruise. He then wants to settle into his retirement. It is therefore recommended that he crystallises the SIPP to pay for the car, the holiday and his first year’s income with the tax free cash of £150,000 (25% of his SIPP fund) and enters flexi-access drawdown with the residual fund but drawing nil income. It is then recommended that in subsequent years he draws his income from the ISA and unit trust portfolio, ensuring that the portion from unit trusts makes full use of his capital gains tax allowance with the balance coming from the ISAs.
This advice works well in two ways:
> Firstly, by drawing income from his non-pension investments Alex’s estate reduces by the amount of income he spends thus reducing his potential inheritance tax bill.
> Secondly, by nominating the drawdown funds to Naomi upon his death, she could then live off her own work pension and the income from Alex’s remaining unit trust and ISA portfolio, and use the drawdown funds to continue in her own flexi-access pension.
Upon Alex’s death, Naomi could then also nominate Emily, her daughter, as a successor to the drawdown fund who in turn can continue in drawdown nominating any of her children as a future beneficiary. When the fund is small enough, the then drawdown holder may decide to cash the pension in for a flexi-access lump sum which may or may not be taxable at their individual marginal rate of tax at the time, depending on whether the previous holder’s death was before or after age 75.
Funds continue to grow 'virtually' tax free
Meanwhile, the investments held within the pension drawdown continue to grow virtually tax free and can be nominated to whomever the holder wants to benefit from the funds. The only drawback from a tax perspective is if any of the holders of the drawdown pension die over the age of 75 in which case there is a special lump sum benefit charge of 45% but no test against the lifetime allowance.