Pension ‘Death Tax’ Abolished From 2015/16

As announced in Budget 2014, the Government recently consulted on allowing members of defined contribution pension schemes complete freedom from April 2015 to access their pension funds from retirement age. As part of this process they also undertook to review the 55% tax charge that can apply when a member dies and their pension fund is paid out to someone else.

The Government has now announced their plans for this 55% ‘death tax’. The charge will be abolished from 6 April 2015 and replaced by a new set of rules.

The new rules will apply by reference to payments on or after 6 April 2015 and can apply even if a member dies before that date.

Under current legislation, the 55% charge broadly applies when a death benefit is paid from a pension fund unless the member died under the age of 75 without having drawn down any of their fund. The rules apply separately to each pension fund (or segment of a pension fund) a member has. So one could have a 55% charge on a fund from which some benefits have been drawn down but not on a separate fund where there has been no drawdown.

The new rules will continue to include a distinction where a member is under 75 when they die. The current and new rules are summarised below.

Current Rules New Rules
Member under 75:
No drawdown Lump sum:    tax-free Lump sum:    tax-free

(Or can use flexible drawdown, also tax-free)

In drawdown Lump sum:    55%

Drawdown:    recipient’s marginal tax rate

Lump sum:    tax-free

Drawdown:    tax-free

Member 75 or over:
No drawdown Lump sum:    55%

Drawdown:    recipient’s marginal tax rate

Lump sum:    45% (see note)

Drawdown:    recipient’s marginal tax rate

In drawdown Lump sum:    55%

Drawdown:    recipient’s marginal tax rate

Lump sum:    45% (see note)

Drawdown:    recipient’s marginal tax rate

 

Note:  The Government will consult on replacing the 45% charge with the recipient’s marginal tax rate from 2016/17

With the temporary tax rate of 45% (for a lump sum where the member is 75 or over when they die) being the same as the top rate of income tax, in most cases it is likely to be tax efficient to use drawdown so that lower marginal rates can be accessed in future.

While the focus has been on defined contribution schemes, defined benefit schemes will also be subject to the new rules.  The main difference for these schemes under the new rules is that drawdown for deaths under 75 will be tax-free rather than taxed at the recipient’s marginal rates.

It is worth highlighting some provisions which will not change:

  1. A tax-free pension commencement lump sum will continue to be available.
  1. Investment growth in the drawdown account will continue to be tax-free.
  1. There will be no change to the interaction with the lifetime allowance.

The new rules remove what has been widely considered as an extension of inheritance tax.  Despite this it will still be important to ensure that a pension fund does not pass into the deceased’s estate so that no inheritance tax arises.

The new rules will offer a tax efficient way for a member to pass their fund to their dependants which should encourage retirement saving.  It may also lead to an increased demand for transfers from final salary schemes to defined contribution schemes to allow the member’s family to continue to benefit after the member and their spouse has died.

By applying the new rules based on the date of payment rather than death there is an opportunity for beneficiaries of members who die before 6 April 2015 to ask for benefits to be deferred so that they can take advantage of the new rules.  This is though subject to an over-riding time limit for the payment of a tax-free lump sum where the member died under 75.  These must be paid out within two years of a scheme administrator being aware of the member’s death.

For further information and advice on issues arising from these new rules please contact the TaxDesk on 0845 4900 509 and ask for Lawrence Adair.