Beware elephant traps

As professional advisers we aim to deal with all of the 'life stages' of our clients and so naturally enough, this also includes death and bereavement - one of the hardest parts of the job.

However as well as being hard, it is typically a time when financial affairs are most in flux and when our advice can be of most value and real importance to a family. The other side of that coin however, is that it's a time where an unexpected elephant trap can lie in wait for the unwary or inexperienced.

I recently encountered one of these potential elephant traps when a client let me know that her husband had passed away. The husband had generally dealt with his own affairs, in particular his quite large self-invested pension which was in drawdown.

My client understood that the pension made up a large part of her late husband's wealth, and so was concerned when the pension company told her that because the pension was in drawdown, taking the money as a lump sum (as she wished to do) would mean a heavy tax penalty of 55 per cent.

However very recently the government has announced significant changes which take effect from April 2015. For those who die before the age of 75, the 55 per cent pension death tax is abolished: even for funds that are in drawdown, the money can be paid out entirely tax-free. For those that die after the age of 75, the beneficiary (who can be any nominated individual and not necessarily a dependent) can inherit the fund tax free, and then draw on it subject to their own income tax rates. As even the highest marginal income tax rate is generally no more than 45 per cent, this still represents a significant saving.

As before however, the money must be paid out to the beneficiary within two years, otherwise a 55 per cent tax charge still applies.

In our own case, because the husband was under 75, our client could (by waiting until after April 2015) avoid the 55 per cent tax entirely. This is because the new rules apply to pension death pay outs after April 2015, i.e. not just for those who die after April 2015; her husband died under the age of 75; and the husband's date of death means the widow won't breach the two-year rule by waiting until April 2015.

If circumstances were different and our client hadn't had the option of waiting until April 2015 (if, say, the two year window didn't extend that far), it would be easy to assume she must pay the 55 per cent. But this is another potential elephant trap because there is a relatively simple alternative which enables spouses, civil partners or financial dependants (which can include siblings but not children) to sidestep the tax.

Instead of opting for the lump sum less 55 per cent tax, inheritors can elect (subject to scheme rules) to use the fund for pension drawdown in their own name. This option allows an income to be taken which (like the late pensioner's income would have been) is based on their own age, fund value and prevailing gilt rate.

If a regular income doesn't suit your client's planning needs, pension drawdown also offers the option of flexible drawdown, which allows the income to be exercised without imposing yearly maximums.
In effect the fund can be taken as a single lump sum,
or series of lump sums.

Normal income tax is payable as on any pension income and sums taken under flexible drawdown are no different. It is currently only available for people who already have at least £12,000 in secured pension income, but from April 2015, even that restriction falls away. If the dependent is a basic rate or non-taxpayer (and can spread the lump sum payments over a number of tax years so as not to breach the tax thresholds) then the saving could potentially be much greater.

With drawdown pension funds typically being in six figures, the potential tax savings from sidestepping the 55 per cent lump sum death tax is an advice opportunity for the aware professional, and a potential elephant trap for the unwary one.

Scott Gallacher is a director at Rowley Turton

He writes the regular IFA comment in Private Client Adviser