Protecting your Pension Death Benefits

It is rare to find a solution to a problem which is simple, easy and cost effective but remains (a) relatively unknown and (b) rarely used.

Here’s the problem: death benefits attached to pension plans can often end up being paid out without any protection against Inheritance Tax (IHT).

Millions of people have a pension and there is really only two possible ways this pension will ever pay out:

  1. On retirement
  2. On death before retirement.

Although it is highly likely in any given case that the pension will be paid out on retirement, there are sadly still many cases where the pension holder will die before they retire.

It is these cases where the problem exists.

The rules around death benefits in this instances can be complex and we do not wish to focus on these complexities, so the following is a simple overview of the situation and the resulting outcomes.

A pension will normally pay out its underlying value on death or a higher death benefit if applicable, so for example, there are some schemes where a multiple of the employee’s salary is payable.

Either which way it is probable that the pension administrators will pay the value of this benefit to a person or persons as directed by the pension holders ‘expression of wish’ form, if one exists or, if not, to the pension holder’s next of kin. Sometimes these expression of wishes forms could have been filled out many years before and could be complicated by a changed circumstance (another complication!).

To illustrate why this may be a problem, take the example of Mr and Mrs Penguin who have the following assets:

IHT

Mr Penguin has expressed a wish that his pension be paid to his wife on his death.

Unfortunately Mr Penguin dies and the value is now paid to his wife – she receives £400,000

The issue now is that she now has an estate of £1.3 million. Anything above £650,000 (2x the Nil Rate Band) will be taxed at 40%. The result of this is that the pension fund will now pay £160,000 towards this tax (40% of the £400,000 pension fund mentioned earlier).

IHT2

The pension ‘contribution’ to this overall figure could have been reduced entirely with a simple mechanism known as a Pension Trust, incredibly simple to implement and very straightforward in every respect.

The effect of this spousal Pension Trust is to allow the £400,000 pension benefit to be paid into a trust, from which Mrs Penguin may draw, so she still has complete unfettered access to the money. However the trust does not form part of her estate. You can see therefore that this immediately reduces the future IHT liability by £160,000 when she dies.

IHT3

It may even be better than this because any loans she draws from the trust will need to be repaid on her death and this liability could reduce her estate even further.

Over and above this there is a further, crucial benefit of using a Pension Trust; it also helps protect against a remarriage further down the line for the survivor, which then subsequently ends in a divorce. Or against a remarriage where other children (not those of the deceased) are brought into the equation. This is known as bloodline planning, the effect of the bypass trust is to ensure the money remains in the bloodline of the deceased pension holder and protects not only against unwanted and unnecessary tax, but against unforeseen future challenges in the case of a later divorce or other financial calamity. The trust acts as a long term guard against all of this.

This idea is so simple, so effective and completely without any downside that it really should be a mass market approach, why would anyone have a significant ‘death benefit’ attached to a pension who would not adopt this approach to protecting it?

As stated earlier, dealing with pension schemes, trustees, tax, death benefits etc. can – and often will – have complexities attached, however this basic idea outlined will normally be manageable in terms of its implementation, even if you require an expert hand to make sure it is adopted accordingly.

However pound for pound, this must be one of the most effective tax saving ideas around and as it is one which effects (and could benefit) millions of people, it should be pursued wherever feasible.

You should seek advice to see whether you may be able to profit from this. Call us on 0800 211 8526