Spend a little to save a lot

Inheritance tax makes most investor’s blood boil. This is before they realise that the value of their pension could also to be subject to 40 per cent tax. Avoiding inheritance tax on a pension fund requires some thought and planning.

Most pensions have attractive death benefits from a tax perspective. If you die before you retire the value of the pension fund is normally payable tax free to your nominated beneficiaries, usually your spouse. Pension investors, understanding that the benefits are tax free, assume that there is no more that needs doing.

However, if the pension death benefits are paid direct to your spouse, these benefits are received as cash. This cash can be spent, invested or gifted as your spouse sees fit. But on your spouse’s subsequent death, if this cash has not been spent, it forms part of their estate. Cash is not tax free and could easily be subject to inheritance tax (IHT) of up to 40 per cent when passed onto children or grandchildren.

One solution to avoid this problem is to have the death benefits paid directly to your beneficiaries (usually children or grandchildren). The pension death benefits are tax free at the point they are paid, so can cross generations and be paid as cash without passing through your spouse’s estate.

The downside of this route is that your spouse then has no access or rights to the proceeds of your pension fund, which of course they may need to live on. At the same time, cash might be passed into your children or grandchildren’s hands at too young an age.

The alternative is to have the pension death benefits paid into a trust. With this solution the death benefits from the pensions are paid straight to the trust as cash, normally free of inheritance tax. Under the terms of the trust the trustees have to the ability to distribute monies at their discretion. These distributions may be made to the spouse or any other trust beneficiaries. The spouse is usually one of the trustees so has some say in the distributions.

The advantage behind this arrangement is that the value of the death benefits are held in the trust free from inheritance tax and can be released to the beneficiaries (children or grandchildren) when appropriate. However, under the terms of the trust, monies can also be released to the surviving spouse if needed.

Funds that are paid from the trust to the spouse revert to the spouse’s estate and on death are subject to IHT. One of the ways to minimise this is to make loans from the trust rather than direct payments of trust assets. This creates a debt against the spouse’s estate, which can reduce IHT on their death.

Whilst monies remain in the trust they can be invested to generate a return. For shorter terms, cash is normally appropriate and for longer terms, equity and fixed interest portfolios are generally suitable. The investment decisions are made by the trustees and these will depend upon the frequency and size of distributions.

If it is clear that the surviving spouse is not going to need any of the proceeds of the pension funds, the trust assets can immediately be distributed to the beneficiaries if appropriate.

What types of trust are used?

In many wills, trusts are created on death to hold assets. Known as discretionary will trusts, these were predominantly used to save inheritance tax. However, since transferable IHT thresholds were introduced, negating the need from a tax perspective, will trusts are now used purely for asset control or protection. Pension death benefits can easily be paid into a will trust.

Alternatively, you could set up a spousal bypass trust to accommodate the pension death benefits. An unfortunate name that sounds like a medical procedure, a spousal bypass trust (SBT) is a simple discretionary trust. The main difference between a SBT and a will trust is that the will trust is created on death, where as the SBT needs to be established before death. Setting up a SBT with your solicitor is straightforward and shouldn’t cost more than a few hundred pounds. While you are doing this it makes sense to review your Will at the same time.

Once you have decided what types of trust to use, simple (and free) nominations of beneficiary are required, instructing your pension provider to pay the death benefits direct to the trust. Your pension provider can supply these to you.

NB

Pensions may not always be tax free on death. If you make payments into a pension with the view to avoiding tax i.e. if you make death bed payments (considered as being 2 years before death) into a pension deliberately to avoid tax, HMRC can apply an inheritance tax charge.

If you die while you are drawing an income from your pension, via income drawdown there is a 35 per cent income tax charge deducted before the balance is paid to your beneficiaries or spouse as cash. The cash, once in your spouse's estate, could be then liable for a further 40 per cent IHT charge on their subsequent death, an effective 61 per cent tax rate.

Danny Cox is a chartered financial planner at IFA Hargreaves Lansdown. The comments are his own and do not necessarily reflect those of his company.