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JUNE 2011

The rules governing the taxation of lump sum death benefits from pension funds have recently changed. The new regime opens up the available estate planning options and with appropriate planning, inheritance tax can be minimised. 

The new rules came into force on 6 April 2011, although the old regime still applies to deaths that occurred prior to that date. Previously, where an individual died after the age of 75, many pension schemes allowed the payment of lump sum death benefits to charities only. Where lump sum payments could be paid to family members, they were subject to a tax charge of 82%. Consequently, the intended beneficiaries would have received only a tiny fraction of the lump sum benefit.

From 6 April 2011 onwards, a reduced rate of tax applies to lump sum death benefits payable to the family on death of a pension scheme member over the age of 75. Under the new rules, where the deceased had begun to draw their pension, a rate of 55% will be applied to the lump sum on death benefit - a significant tax reduction. 

The new rate of 55% will also apply to lump sum death benefits payable in respect of individuals who die before the age of 75 and who had begun to take benefits from their pension fund. Under the old regime, those payments were taxed at a lower rate of 35% and the new rules are therefore less beneficial in those circumstances.

However, where an individual dies before the age of 75 and has not yet drawn any benefits, lump sum death benefits can be paid free of inheritance tax.

This table may clarify the situation:-

If the deceased leaves a surviving spouse, the survivor can opt between continuing to draw benefits from the pension and taking a lump sum death benefit. The decision will affect the tax treatment of the inherited benefits as taking a lump sum death benefit will trigger an immediate tax charge. In contrast, if the surviving spouse continues to draw benefits, no tax will be payable on those benefits until the surviving spouse dies.

However, if the surviving spouse chooses to draw benefits instead of opting for a lump sum death benefit, a number of issues may arise:-

1. The final destination of the residual death benefit for the survivor’s drawdown fund will rest with the surviving spouse. This could be problematic for the spouse who died, especially if they leave children from a first marriage.
2. If the survivor loses mental capacity, no appropriate decision can be made unless they have a lasting power of attorney in place.
3. The survivor may remarry and leave everything to their new spouse.

These problems can be avoided by putting in place a discretionary trust to receive the lump sum death benefit on the death of the first spouse. This will give the pension holder peace of mind over how their death benefits are distributed.

A discretionary trust will enable the pension holder to retain an element of control. They can create the trust during their lifetime and stipulate by letter of guidance to the trustees the preferred recipients of their death benefits. A discretionary trust is also a tax efficient way to distribute lump sum death benefits as they will not form part of the surviving spouse's estate and will therefore not be subject to inheritance tax on their death although they can benefit from the trust fund.

A further benefit of placing lump sum death benefits in a discretionary trust is that the trustees can make loans to beneficiaries, including the surviving spouse. Those loans would then be deducted from the estate of the survivor on their death, resulting in further tax savings. Payments out of the trust can be made on a planned basis to minimise tax charges.

Now is a good time to review your pension death benefits and the best way to preserve benefits for your family. A discretionary trust may be a tax efficient solution as well as giving you peace of mind that the interests of your family members will be protected. 

These trusts have to be drafted specifically with reference to the rules of your particular pension plan.

Clare Jeffries
Partner

If you require any further information about the issues raised in this article please contact Clare Jeffries (cjeffries@gdlaw.co.uk),  or any other member of Goodman Derrick LLP’s Private Client  Team on 0207 404 0606.