Despite improved annuity returns in the past two or three years, a much higher proportion of those reaching retirement are choosing instead to leave their pension invested and take a flexible drawdown arrangement.
There are several attractions to this approach, and for some people it is the knowledge that when they die, the remainder of their pension pot will pass on to their dependents; an annuity will either die with the holder (after a minimum period) or else pay out a widow(er)’s benefit until their subsequent death.
There is a widespread belief that pensions pots fall outside the reach of inheritance tax, and to an extent this is true, but only up to a point: if the pension holder dies before their 75thbirthday, then no tax is payable provided the sum falls within the member’s ‘lump sum and death benefit allowance’ (LSDBA), currently £1,073,100.
However, if the pension holder is over 75 when they die, any lump sum death benefit (in other words, the amount left in the pension pot which is passed on to a beneficiary or beneficiaries) is subject to tax. And that isn’t inheritance tax, with its zero-rate allowances; it is counted as taxable income.
So the entire sum will be taxed at the beneficiary’s marginal tax rate, which for an additional rate taxpayer would mean 45%. The lump sum is taxed in the year it is received, so it doesn’t need a particularly large pension pot to trigger a substantial tax bill.
Fortunately there is a better way. Modern drawdown contracts can include ‘inherited drawdown’, by which a beneficiary can continue to draw an income from the pension pot flexibly until it is exhausted. This obviously gives them the opportunity to regulate the amount they draw in any one year so that they can plan their resultant tax, perhaps limiting their income to stay under a particular tax threshold.
Importantly, receiving drawdown income as a beneficiary does not affect your ability to continue to contribute to your own pension pot, in the way that drawing down income from your own pension would. The beneficiary doesn’t have to be aged 55 or over, either.
What’s more, the beneficiary can then nominate their own beneficiary to continue receiving drawn-down income when they themselves die, allowing pension savings to pass down through more than one generation. And if the beneficiary dies before they are 75, then the next generation of beneficiary can take withdrawals from the drawdown account tax-free.
This can be a particularly effective way of managing future inheritance tax liabilities where there is a large estate.
For those approaching retirement, the advantages of choosing a more modern drawdown contract with beneficiary drawdown are clear, especially for those with large pension pots. Those already on more traditional drawdown contracts could be able to make the switch – and for those who have either turned 75 or are approaching their 75th birthday, this is something well worth taking advice about.