The negative effects of recent changes in the rules for drawdown pension death benefit payments can be mitigated, as fictional IFA David Peckham tells his client, writes AXA Wealth's Mike Morrison.
David Peckham has just returned from holiday and, as he sits in the boardroom waiting for his client, his two weeks of sun, sea and sangria seem but a distant memory. His meeting with Bryan Riggs is to explain the changes in the rules for drawdown pension death benefit payments.
The two men grew up together and it seemed logical that David would become Bryan’s adviser. The meeting has been arranged since late April, but Bryan has been somewhat elusive and circumstances have made it difficult for them to get together until now. David reads the briefing note his paraplanner has prepared for the meeting.
Bryan is 56 and has a large Sipp fund from which he has drawn the pension commencement lump sum (PCLS) at 55 but then drawn no income. David had not known why the need for the cash had arisen so quickly, but one thing he has learned over the years is that Bryan has many dealings that he keeps very close to his chest.
Death benefit changes
David plans to tell Bryan about the changes in the rules for drawdown pension death benefit payments after 6 April. He reads through the note of the meeting when Bryan had taken the lump sum.
He had explained to him then that one of the consequences of drawing the money would be a tax charge of 35% on Bryan’s death if the fund was used to provide a lump sum. Bryan had accepted that and, indeed, they had set up a spousal bypass trust so the residual fund could potentially be paid to Bryan’s two children from his first marriage. Bryan has provided a letter of wishes to the trustees of the bypass trust to explain this.
As part of the review process David has initiated for existing clients, he needs to explain the revised rules to Bryan and break the news that the potential lump-sum death benefit tax charge has increased to 55%.
Bryan arrives and David’s first comment, after shaking hands, is to suggest that he looks a bit tired. Bryan smiles: ‘Too many late nights!’
Getting down to business, David explains the change in the rules and how, in essence, drawdown has become more flexible. However, he continues, two of the changes that have provoked industry comment have been the worsening of the Government Actuary Department rates that govern how much Bryan is able to draw from his crystallised drawdown pension fund, and the increase in the lump-sum death benefit tax charge.
Bryan listens carefully, then asks whether there are any situations in which he can avoid the tax charge. David’s file includes a reminder that Bryan has remarried.
David explains: ‘Well, a lump-sum death benefit could be paid from your drawdown pension fund to one or more UK charities, tax free. However, if you did not want to do that, rather than pay a lump sum from your drawdown fund, your current wife could take over your drawdown pension fund and draw any required income from it, subject to HM Revenue & Customs’ [HMRC] drawdown limits. This option would not be subject to a 55% tax charge, but any income actually drawn would be subject to income tax at the marginal income tax rate.’
Bryan asks: ‘Does that affect my ability to ensure my two eldest children from my first marriage are taken care of on my demise? As you know, one of my key aims was to make sure they got the money and, through your kind assistance, we put in place a trust structure to ensure this result.’
David sits back and thinks for a minute. ‘In reality, if your wife took over your drawdown pension fund and continued drawdown in her name, she could use the money as she wished and she could choose not to make any provision for your eldest two children. It might be something for you to discuss with her.’
‘I am not so sure about that!’ quips Bryan, enigmatically.
David continues: ‘You could also consider drawing up to the maximum allowable income from your drawdown pension fund. You could then consider gifting any surplus income to your children, or any other recipient, either directly or via a trust. This could also reduce any potential inheritance tax bill on your death. Another option, as you have ongoing earnings, is you could pay some of the drawdown pension income back into your pension plan as new contributions.
‘You would be taxed on the drawdown pension income via the pay-as-you-earn system but you would get tax relief on the new pension contributions, although any higher rate or additional rate tax relief would have to be claimed as part of the self-assessment process.
‘The advantages of doing this are: first, you would decrease your drawdown pension fund, on which the 55% lump sum death benefit tax charge would be levied; and second, the new contributions and any associated growth would form an uncrystallised fund from which you could take another 25% as a PCLS at any time and use the rest of your fund to provide further income during your lifetime.
‘However, if you died before taking any PCLS or income benefits from this fund, no lump sum death benefit tax charge would apply to it.’
‘That sounds too good to be true. Is it really that simple?’ Bryan asks.
‘Well, we do have to watch out for the recycling rules,’ says David. ‘HMRC could decide that the only reason you took your lump sum last year was to enable you to make new contributions and obtain more income tax relief, but I do not think HMRC would take this view.
‘Basically, an individual would not currently be affected by the recycling rules if the amount of their PCLS payment, together with any other such lump sum(s) taken in the previous 12-month period, did not exceed £18,000, or if the cumulative amount of the additional contributions did not exceed 30% of the PCLS.
‘The amount you could contribute is below the 30% limit and we also have the advantage that this was not part of a pre-planned exercise, as you are reacting to a later change in the legislation.’
Bryan considers all of this before saying: ‘Sounds good to me, David. As long as I have a few years left and the rules do not change, then I should be okay.’
David smiles to himself. He is learning rapidly that complicated family structures require complicated planning.
Mike Morrison is head of pensions development at AXA Wealth.