Pernicious tax hits surplus pension funds

For many years there was a persistent clamour from the financial community and from aging pensioners for the Government to change the rule that made the purchase of an annuity compulsory for 75 year olds with non-vested pension funds.  This was because pensioners wished to keep their funds intact for their beneficiaries to inherit when they finally departed this mortal coil rather than pay out the accumulated fund in exchange for what was often a surplus and highly-taxed income.  Similar funds for those departing before age 75 had been available for payment to beneficiaries free of Inheritance Tax (IHT) and with increasing life expectancies it was becoming obvious that compulsory annuities at this increasingly young age were a problem.

 Gordon Brown came up with a great solution – the Alternatively Secured Pension or ASP.  This was launched in April 2006 having been mooted as long ago as 2003.  It allegedly came about as a result of the Plymouth Brethren objecting to being forced into ‘gambling’ on life expectation – which is how they view annuities.  Gordon Brown took due notice of their concerns and introduced ASPs aimed at those with principled religious objections to annuities. 

 As he has subsequently pointed out many times, they were never intended as a means for wealthy people to pass on tax-advantaged savings to dependents.  In other words, although residual pension funds left by pensioners dying before age 75 can be passed to beneficiaries, he is determined that those living beyond that arbitrary age should be committed to either taking an annuity or losing their funds to the tax man!  This is why he launched the concept in April 2006 and effectively knocked it on the head again in December 2006 by imposing a tax and penalty charge of up to 82% on residual funds!

 So in effect we are back to taking our pensions by some means or another before age 75 and finding an alternative route to diverting them to our families in the most tax-effective manner possible.  This is particularly the case for all those post-war baby boomers who have acquired non-pension assets well in excess of their likely lifetime needs in addition to healthy and ‘surplus’ pension funds.

Is there an alternative means of dealing with a surplus pension fund of £1 million which can both:
           a)      Allow beneficiaries to receive more than the derisory 18% on offer if it goes into ASP?
           b)      Avoid the compulsory income accumulating in the individual’s estate and thus inflating their IHT liabilities?

 The simple answer is yes, and how some!  Although the saver does not need the money the sensible approach is to take the maximum tax free lump sum (of 25%) early on in the process.  On £1 million this will equate to £250,000 which can conveniently be gifted into a flexible IHT mitigation trust to remove it from the tax man’s reach whilst retaining flexible planned access.  So long as the saver/settlor survives seven years this will become IHT free ready to be passed to beneficiaries whenever it appears appropriate (this option is available under a flexible trust during the life of the settlor). 

 Maximum pension/drawdown should then be taken.  This may suffer 40% Income Tax but since (a) it derives from savings which probably enjoyed this level of relief when contributions were made and (b) it has grown in a tax-free environment within the exempt fund, such a tax can be considered neutral.  The ‘pensioner’ will then be in possession of regular slugs of net income.  Of course this is taxed income which is surplus to living requirements and is regular.  Hey presto an obvious candidate for ‘normal expenditure’ gifting.

 Now I am not going to suggest that the recipient gifts this money to his or her beneficiaries completely and immediately free of IHT from that point until death – although I could.  It would seem quite tax efficient.  No I am going to suggest that he or she gifts it, on an immediately exempt basis, into another flexible IHT mitigation trust so  that it too can be available to the pensioner should it ever be necessary.  However, just as with the lump sum arrangement the trustees can also make monies available to beneficiaries during the settlor’s lifetime should this be necessary.

 To put this effect into context consider the retiree who has an untouched pension fund of £1 million and dies one month before his 75th birthday.  His beneficiaries can inherit the whole fund entirely free of IHT.  Contrast this with the same person who lives the extra month and is all set to take his pension under the ASP rules.  He dies within the first month and because he has already gone into ASP his beneficiaries suffer the full 82% tax and penalties and receive only £180,000 (rather than the £1 million they previously would have received).  Can this be right?  The arbitrary nature of the 75 year old deadline is crass to say the least.  This immediately begs the question as to whether the retiree should have taken the tax free lump sum and entered drawdown just before his birthday.  This is a great idea except that a male aged 75 has a life expectation of something like 9 years which is perilously close to the 7 years needed to move the tax free cash outside his estate and escape IHT.  It will also leave 75% of his fund at the mercy of the 82% tax.  Were he to do this and then die his estate would potentially suffer 40% on the tax free cash (40% of say £250,000 leaving £150,000) and 82% on the residual £750,000 fund (leaving 18% of £750,000 which is £135,000).  This would still be worthwhile compared with not taking the tax free cash (beneficiaries would potentially receive £285,000 rather than £180,000) but we can do even better.

 The trick is to take the tax free cash and enter drawdown early enough to reduce the residual fund.  Every monthly pension payment which is taken and transferred into a ‘normal expenditure’ scheme will help address the balance between exempt monies withdrawn and residual fund left behind.  The drawback of this is that the impact of any early IHT charge on the tax free cash and the Income Tax payable on drawings will improve matters greatly for anyone living beyond 75 but will inevitably dilute the returns to beneficiaries if the retiree dies before 75 when the fund would have otherwise been payable free of IHT.

 The following graph shows the impact of taking action early for a retiree aged 66.  The blue line represents the net proceeds available to beneficiaries if the fund is kept until age 75 then goes into drawdown after taking tax free cash.  The red line shows net proceeds if early action is taken.  There is little doubt that the single IHT gift plus normal expenditure route is highly effective beyond 75, especially if the arrangement is started early.  The only difficulty arises if the retiree dies before attaining 75.  This can be simply addressed by the purchase of term assurance in trust to cover the shortfall.  Rates for cover for a 66 year old male per £100,000 of cover are approximately £80 per month for 7 year term (to cover the inter vivos period) and approximately £100 per month for cover to age 75.  This is effective financial planning at its best and makes a good fist of overcoming the pernicious taxes and penalties imposed by Gordon Brown on ASPs in the last Budget. 

Assumptions:  Income Tax Rate 40%; Net annual growth rate 6%; 15yr Index Gilt Yield 4.81%;
Drawdown basis 7.5%; Table annuity rate age 75 10.2%; IHT NRB used elsewhere.

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 6th November, 2007 |
Comments: Have Your Say