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Tax Doctor: Three steps to reduce tax on death benefits

Tax Doctor: Three steps to reduce tax on death benefits

One of Ian’s longest-standing clients, David, had recently passed away. The administrators of David’s Sipp had used their discretion to choose his widow, Julie, as the beneficiary.

A sudden situation

David’s death in his late 50s was unexpected. His Sipp had grown strongly in the past couple of years and was worth around £1.5 million when he died. He did not hold any form of protection. Back in 2014 his fund had not been big enough for individual protection and it was felt there was still a need for contributions. Neither of the 2016 protections had been applied for because there was no closing date for them and David had not been planning to crystallise his fund soon.

Unfortunately, David’s death benefits were likely to be tested against the lifetime allowance (LTA), and the benefits were valued at around £500,000 more than the standard allowance.

Not too late

Although David had not applied for any protections during his lifetime, the opportunity to do so might not have been lost. Ian checked HM Revenue & Custom’s rules, which confirmed that David’s personal representatives were able to apply for the protection after his death.

Although contributions had been paid in 2015, none had been made since 6 April 2016. This meant fixed protection of £1.25 million was an option. A tax charge on £250,000 could be wiped out immediately.

Taxation troubles

Next, Ian considered how the benefits would be taxed. Julie should not have to pay income tax on the death benefits as David had died before reaching 75. However, she would have to pay a LTA charge on around £250,000.

If Julie received the death benefits as a lump sum the tax charge would be 55%, or £137,500. Alternatively, if Julie designated the benefits into dependant’s drawdown, the tax charge would only be 25%, or £62,500. In either case the LTA charge would fall on Julie personally, rather than being paid out of the pension scheme as it normally would have been had David crystallised funds while still alive.

But the assets Julie was set to inherit through the estate were illiquid, so she would need to receive a lump sum in order to pay the LTA tax charge.

Simple solution

Julie could set up a regular income, tax-free, from the drawdown pot to cover her outgoings, although there was nothing to stop her taking an immediate lump sum to cover the LTA charge.

Even were Ian to come across a situation where a beneficiary wanted to receive the whole fund in one go, if this would involve a LTA charge, it would make more sense to designate to drawdown, receive a one-off pension payment, and pay a 25% lifetime allowance charge, than take the payment as a lump sum and pay 55%.

Gareth James, head of technical resources, AJ Bell

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