Looking Ahead series: Autumn Budget 2024 - article eight
The 2015 defined contribution (DC) pension freedoms, combined with private sector employers’ retreat from defined benefit provision, means that more pension wealth is set to be bequeathed.
Even where DC savers who choose not to annuitise intend to spend their pension savings during retirement, they do not know when they will die. Earlier-than-expected deaths and fear of running out of money mean that many will die with assets in their pension pot.
Moreover, some will aim not to spend their pension savings – they want to leave money to their children/others and bequeathing pension assets can have tax advantages.
Where the saver dies before age 75, DC assets that are bequeathed to a beneficiary’s drawdown arrangement are free from income tax – so tax on the income that the saver put aside is ultimately cancelled rather than just deferred. That tax-free status is preserved even if the beneficiary withdraws everything in one go.
Where, more commonly, a saver dies after 75, the beneficiary of a drawdown account will be assessable to income tax on amounts withdrawn, but withdrawals can be spread over a number of years for tax planning purposes (e.g., utilising personal allowances).
Pension assets also do not form part of estates for Inheritance Tax (IHT) purposes, provided that their distribution is at the scheme’s discretion (which is overwhelmingly the case) rather than following a binding instruction.
With every year that passes, more people will retire in a “pension freedom” environment, and DC pensions will represent a greater share of their pension wealth. 2024/25 looks set to be the milestone year when more new retirees begin accessing their pensions in a form that does not involve a lifetime income than through DB pensions or annuities[1]. And every year will see more money saved in the expectation that the current tax treatment will apply. DC pensions are increasingly being used as intergenerational wealth transfer vehicles.
Institutionally, HM Treasury may therefore be concerned that the nettle of changing pension “death taxes” will become progressively harder to grasp. Jeremy Hunt’s former special adviser recently wrote that the estate planning opportunity associated with pension saving “is a particular concern to Treasury officials now that the lifetime allowance has been abolished.”[2]
The Institute for Fiscal Studies (IFS) estimated that bringing pensions within the scope of IHT could raise between around £1bn and almost £2bn a year[3].
It is hard to justify taxing inherited pension wealth where the saver died aged 75, but not where the saver died aged 74 years and 364 days. However, this is (broadly) the current position. If ministers asked their officials how we ended up here, it would be explained that this had occurred through a series of not-necessarily coherent policy changes.
If the Government wants a coherent policy on the tax treatment of death benefits – and doesn’t want all death benefits to always be tax-free – it first needs to make some hard choices. It could, for example, always apply income tax, but that would make for poor media headlines when a worker dies aged, say, 40 with a non-working partner and young children (particularly as, currently, the lump sum would be tax- free).
The question then becomes what factor(s) should determine whether a lump sum death benefit is taxable? It could be an age, which is arbitrary (and is currently tied to 75). Or it could be whether benefits have been crystallised (since the member will usually have then had the opportunity to take tax-free cash), although in a world of DC freedoms, individuals can crystallise only the amount of money they “need”.
Where a pensioner who has taken a tax-free lump sum and allocated the remainder of their pot to drawdown dies before 75, making the beneficiary’s income withdrawals assessable to income tax would restore the pre-2015 tax treatment and move towards comparable tax treatment between DC and DB arrangements.
Funds that had not been designated for drawdown where death occurred before 75, could, as now, be tested against available lump sum and death benefit allowance (LSDBA; the standard level is £1,073,100 equal to the old LTA) and, provided that there was no excess the amount could be paid – as a lump sum or through income drawdown – tax free. This is the same principle as applies for lump sum death benefits payable from a DB arrangement where a member dies before age 75.
Where death was over 75 there would (as now) be no LSDBA test, but the resultant benefit, whether a lump sum or bequeathed to a beneficiary’s drawdown account, would be taxable.
Scheme pensions (DB) paid to dependants are taxable irrespective of the member’s age at death. For deaths younger than 75, DC dependant’s annuities and beneficiary’s drawdown are payable tax free. A de facto lump sum above the available LSDBA can also be paid tax-free within DC by providing it as a single instalment of “income” through a drawdown arrangement. A Government changing the rules might look to introduce more consistency.
In his recent book, Torsten Bell, a newly elected Labour MP, argues: “Pension pots also need to be included within taxable estates to avoid a clear incentive for them to be used to pass on wealth tax-free rather than to provide an income in retirement”[7].
If the Government wanted to bring pension wealth into IHT estates, one question would be whether to reduce its valuation where income tax would be charged on withdrawals (i.e. to mitigate overlap of different taxes/double taxation). Alternatively, as the Institute for Fiscal Studies has suggested, the income tax treatment of bequeathed funds might be changed, with those funds charged a flat rate of income tax (potentially at the basic rate) and the net pension wealth then forming part of the estate[8].
There would also be questions about how to integrate the deceased’s pension balance into their estate (or otherwise aggregate the two values to determine whether the IHT threshold is exceeded) when a separate trust has discretion over the pension’s use, and whether the pension scheme would be able to pay benefits immediately or would have to wait until the estate had been settled (which can take many months).
Pension schemes seek to settle death claims urgently. It is quite common that the intended recipient of the death benefit is the partner of the deceased, without their own income. The deceased individual’s income (employment and/or pension) will cease – often unexpectedly – yet the costs of everyday living and running a home (rent/mortgage, utility bills, food etc) will not. Delays in paying benefits could be financially ruinous.
If the pension balance were not transferred to the estate, there would need to be a rule for apportioning IHT liability. Historic practice when ASP assets were assessed for IHT was to see whether the estate used up all of the nil rate band and, if so, subject the entire pension bequest to IHT. An alternative approach might be to compare the combined value of the estate and the pension pot with the IHT threshold; if combined assets were 20% higher than the IHT threshold, IHT could be charged on 20% of the pension value and on 20% of the estate value.
A second question would be whether IHT would have to be deducted before pension assets could be distributed, or whether it could be recovered afterwards. If trustees were free to distribute pension assets while estates were being valued, they might have distributed them to multiple beneficiaries, some of whom might no longer have available assets to pay any demand for IHT due (e.g., if they had used any bequest to pay down a mortgage). Schemes that made payments without deductions would need to warn members that they may have to settle a tax charge later.
These are insurance schemes that provide benefits on death, which sit outside the registered pension scheme tax regime. These provide death benefits without assessment against the LSDBA and are not normally assessable against IHT. If death benefits from registered pension schemes were brought within scope of IHT, the Government might consider that the same treatment would be needed for excepted group life schemes.
Instead of, or as well as, changing how bequeathed pension assets are taxed, policymakers could seek to ensure that more money leaves people’s pension pots while they are still alive.
The briefing document published alongside the King’s Speech says DC schemes will be required “to offer retirement products so people have a pension and not just a savings pot when they stop work”[9]. If that were to mean prescribing that default retirement income solutions must be a form that pools longevity risk across savers (a very big “if” – this goes beyond what the Government has said), there would be less money bequeathed. However, that may only affect new retirements and not the existing stock. HM Treasury might also worry that it would lead to less tax revenue in the early years as fewer pots are cashed out.
Alternatively, in a move that would require changing tax legislation but not tax rates, the Government could require minimum withdrawals from DC pots (or from DC pots above a certain balance), as happens in some jurisdictions such as the US and Australia.
For deaths after 75, the IFS has proposed a minimum tax rate for withdrawals, to avoid money that was tax-free on the way into the pension being tax-free on its way out where the beneficiaries (e.g., student children/grandchildren) have unused personal allowances.
