Stuck in the ancien regime when inheriting pensions

published 25 May 2018

897-rugby-634 — Aviva: pension sticklers can be infuriating

You should be able to inherit pensions flexibly, but not all providers will help.

The rules on inheriting pension savings are supposed to be simple and are often hailed as one of the best aspects of the pensions freedom reforms introduced three years ago. But while the rules should mean most people pay no tax for inheriting pension savings from someone who dies before reaching 75, the failure of some pension providers to update their practices means that not every beneficiary will be able to take advantage of this perk.

Certain policies set up some time ago don't allow people to take full advantage of the pensions freedom rules, reports The Daily Telegraph, including some from Aviva, one of the UK's biggest providers.

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A costly inheritance

Since pensions freedom reforms, most people inheriting pension assets from someone who dies before they turn 75 pay no income or inheritance tax (IHT). In theory, they can choose how to receive the windfall as a cash lump sum or as an income, paid either via an annuity or pension drawdown.

However, providers are not required to offer all of these options some, such as Aviva, have not updated older policies and require beneficiaries to take the pension as a lump sum. This means that, while the heirs have no tax liability when they receive the money, they could be hit with income and capital-gains tax charges on any investment returns they earn on the cash in future. In addition, their own heirs may face an IHT liability if they eventually inherit the money.

By contrast, where heirs receive the pension cash through an income-drawdown arrangement, they continue benefiting from the protection of a pension wrapper. As a result, income and capital-gains tax on further investment of the savings is tax-free, and it could be left to heirs with no inheritance-tax liability.

The only way around the problem if you are caught out like this is to try to reinvest the savings in tax-efficient schemes a pension plan of your own, for example, or individual savings accounts (Isas). But the strict limits on how much it is possible to invest via pensions and Isas each year means this may not be practical for savers inheriting large sums at the very least, it may take many years to channel money back into tax-efficient savings products.

Providers such as Aviva aren't breaching the law or financial regulation by sticking to the letter of policies that were often set up many years ago, well before the pensions freedom rules were conceived. But their refusal to be flexible is likely to infuriate anyone who is caught out.

Take action now and avoid tax later

Savers whose pension providers don't give their heirs full flexibility on how to receive pension cash should consider transferring to a rival provider, if inheritance planning is on the agenda. It's important to seize the initiative now, rather than leave it to your heirs to resolve the problem. While you should be able to transfer your savings relatively easily, providers may not let your heirs solve the problem in this way.

That said, before considering a transfer, check that you're not giving up valuable benefits such as terms and conditions that are no longer available. For example, some older providers guarantee an annuity income far higher than anything available today.

Finally, bear in mind that under the pensions freedom rules, most pension savers are allowed to nominate a person of their choice to receive their savings, rather than having to pick a dependant. However, this freedom does not extend to members of final-salary pension schemes.

Tax tip of the week

If you make less than £1,000 in turnover (rather than profit) from property that you own during a tax year, then you do not have to pay income tax on this amount, nor do you have to file a tax return declaring the money. This allowance applies to both UK and overseas properties, and both commercial and residential letting but not renting a room out (which has its own, more generous relief), says the Association of Taxation Technicians.

If you have more than one property business, the single £1,000 allowance applies across all of them. Where property turnover exceeds £1,000, you can simply deduct your property-related business expenses in the usual way, or you can claim "partial relief" you can opt to deduct the £1,000 relief from your property income for tax purposes, but you cannot deduct any other expenses.

Don't breach the lifetime allowance

Roughly 2,500 savers were caught out by the lifetime allowance (LTA) on pension savings last year, up from 1,000 in 2016, according to tax-office data. The LTA is currently just over £1m, and if you breach it, you face stiff penalty taxes on the excess. For defined-contribution pension savers, it's a simple matter of checking the size of your pot. But if you have a final-salary or defined-benefit (DB) scheme, it's trickier.

DB schemes are great they pay a guaranteed income based on lifetime earnings, rather than being funded by the pot you've saved. But this also makes it easier for those in DB schemes to breach the LTA (or annual pension limit) without realising it. To check the annual allowance position, DB members need their scheme to provide them with figures showing how the value of their pension has grown over the year. This figure then has to be multiplied by 16 to allow for the fact that they will receive the increase every year in retirement. Similarly, to calculate their LTA figure, they need to multiply the total value of the expected pension by 20.

Use these rules as a rough check if you're near the limits, take professional advice to ascertain your exact position and consider your options.

David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.