Changes in pension rules have given wary investors yet another reason to turn away from annuities.
Until April, retirement savers who had not drawn from their pensions and died before their 75th birthday faced a tax charge of 55% on the fund.
This all changed when pension freedoms were introduced by Chancellor George Osborne at the start of the current tax year.
Now, if a pension saver dies before the age of 75 years old, beneficiaries can inherit the fund up to the lifetime allowance threshold of £1.25 million tax free.
If the saver dies after their 75th birthday, beneficiaries receiving a lump sum pay tax on the fund at 45% – but if they take an income, they pay tax at their marginal rate.
Spending in the right order
From April 2017, this changes again and the entire inherited pension fund is taxed at the beneficiaries’ marginal rate.
This has turned conventional pension planning wisdom upside down.
Until April 2015, estate planners tended to advise the best course of action to save tax was to run down a pension first, as the highest rate of tax was paid against unspent cash.
Now, it’s often more efficient for pensioners to spend cash in ISAs or other investments first and pass on their unspent pensions.
This is because inheritance tax is applied at 40% on the value of any estate over the nil rate band of £325,000, but many beneficiaries will pay income tax on inherited pension funds at their marginal rate, which could be 20%.
Another knock for annuities
The message from estate planners and wealth managers is that pensioners have an opportunity to reduce the inheritance tax on their estates if they spend their money held in different accounts in the right order.
The inheritance rules apply to pensions, but not to cash spent on providing a guaranteed income for life through an annuity.
Only annuities with value or capital protection are covered by the new rules.
In all other cases, the balance of an annuity when someone dies will pass to the insurance company managing the contract.
Another important point about the new inheritance rules for pensions is that previously, only spouses could inherit – but the new rules allow the pension holder to divide and leave the pot to whomever they wish.
