The headline pension news in the draft Finance Bill published on 9th December 2010 was the formal abolition of the requirement to take an annuity at age 75. Of potentially much greater significance for many holders of pension schemes is the removal of the disadvantageous IHT treatment of lump sums paid on death.
From 6 April 2011 lump sum death payments out of registered pension schemes to dependants aged below 75 will no longer be subject to inheritance tax. The law will also be amended so that omissions to draw benefits from qualifying non-UK pension (QNUP) schemes will be beyond challenge by HMRC and so not potentially subject to IHT.
- lump sums paid out on death before age 75 where no draw-down has been made or lump-sum taken, will not be taxable at all; and
- lump sums paid after age 75 or after draw-down has started will be taxed at 55%; but
- there will be no further liability in the form of IHT.
55% may sound like a high rate of tax but this is tax on funds that will have been allowed to accumulate free of income tax and CGT until draw-down commenced, effectively acting as highly efficient roll-up funds.
This means that the effective rate of tax on the draw-down may be no greater than the income tax and CGT that would have been paid on the sums held in the pension fund in lifetime but no tax is payable before the dependants actually receive payments from the pension scheme and they do not suffer the added burden of IHT.
Take the example of a 40% taxpayer who makes the maximum pension savings of £50,000 per year over twenty years. Without the benefit of income tax relief on pension contributions his annual investment would be equivalent to only £30,000 but the tax relief increases his pension pot and the income it generates, so after twenty years he has invested £1million instead of £600,000.
If the investments in his pension fund simply kept pace with inflation of, say, 2.5% and at the same time produced only a modest income return of 2.5%, the value of the fund would have increased in cash terms to perhaps £2.09million. In contrast the £600,000 invested net of tax and suffering the annual depredations of income tax and CGT on 'growth' (in reality tax on inflation) would have increased to about £1.1million.
For a 50% taxpayer the benefits are greater: the net investment would be only £25,000 and more of the income would be taken annually by the top rate of income tax and so made unavailable for reinvestment.
So what then happens on the death of the taxpayer in our example?
- If the contributor dies aged less than 75 and has not drawn down on his pension there is no IHT to pay on the fund of £2.09m and no charge on the funds leaving the pension fund.
- If he is over 75 when he dies and the fund is intact the tax payable will be £1,149,500. That looks like quite an eye-watering sum for the dependants to bear but they still get some £940,500 net.
- But if the funds are not invested in a pension remember that they will be taxed along the way, leaving a fund of £1.1m which then is still subject to IHT at 40% (assuming, quite reasonably, that the IHT nil-rate band has been absorbed by other assets, not least his house and non-pension investments). That takes out IHT of £440,000 and leaves the dependants with just £660,000 net of all taxes.
- Meanwhile the 50% taxpayer would be left with an investment fund worth about £924,000 on which the IHT would be about £369,600, leaving her dependants just £554,400.
- So paying tax at 55% but only paying once saves the contributor in our example £280,500.
Beware the sting in the tax
Drawing down from a pension fund, even subject to the 55% tax charge, can be advantageous, but care is still required. Post-75 draw-downs that are not spent and remain in an estate on death will then suffer a further 40% IHT.