Taxation of a lump sum death benefit paid to an individual or a James Hay Partnership bypass trust

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1 ADVISER FACTSHEET Tech Talk February 2015 Taxation of a lump sum death benefit paid to an individual or a James Hay Partnership bypass trust In light of the Taxation of Pensions Act 2014, this Tech Talk considers the tax implications of a lump sum being paid to an individual or a bypass trust. We detail the taxation of lump sum death benefits under the current and new rules from 6 April 2015, following the death of the member and any subsequent beneficiary. A case study helps to demonstrate the greater flexibility that beneficiaries will have to access pension funds and how it will be possible to control the tax charge on pension funds taken. We compare the subsequent taxation of a lump sum depending on what the recipient an individual versus the trustees of the bypass trust does with it. As well as the tax considerations, we also consider the non-tax advantages of a trust. Finally, it s important to make some comment on how the Taxation of Pensions Act 2014 impacts existing bypass trusts and to consider the future of the bypass trust. Contents Current rules New rules Tax on lump sum payable following death of beneficiary Case study Lump sum paid to an individual Lump sum paid to trustees of a bypass trust Impact of new rules on existing bypass trusts Comment For professional advisers only

2 Current rules payments made to 5 April 2015 Currently, the payment of a lump sum death benefit will attract a special lump sum death benefit charge of 55% if the pension fund is crystallised, or the member is over 75 at the time of their death. If neither of these conditions apply, then a lump sum up to the member s remaining lifetime allowance could be paid tax free, with any excess subject to a lifetime allowance charge of 55%. New rules payments made from 6 April 2015 Payment made where member dies under age 75 From 6 April 2015, the payment of a lump sum death benefit will be tax free if the member dies under age 75, regardless of whether the pension fund is crystallised or not. This is on the basis that payment is made before the end of the period of two years, beginning with the earlier of the day on which the scheme administrator first knew of the member s death and the day on which the scheme administrator could first reasonably have been expected to have known of it. Where a member dies under age 75 and an uncrystallised lump sum death benefit is paid out within two years, this will be a benefit crystallisation event. If the lump sum is paid outside the two year period, there is no benefit crystallisation event so no possibility of a lifetime allowance charge. However, the special lump sum death benefit charge of 45% would apply. A lump sum paid from crystallised funds outside the two year period would attract a lump sum death benefit charge of 45%, but there is no test against the member s lifetime allowance. Payment made where member dies over age 75 A special lump sum death benefit charge of 45% will be levied where the member dies aged 75 and over. The intention is that from 6 April 2016, the tax charge will be based on the recipient s marginal rate of tax. Overall conclusion To summarise, age of the member is, therefore, the critical factor in determining the rate of tax to be applied to the lump sum payment. To whom the lump sum payment is made, has no bearing on the tax rate applied in the 2015/16 tax year. Taxation of lump sum death benefits payable following the death of a beneficiary The tax treatment of a lump sum death benefit payable on second death should also be considered, for example, the situation where the member s fund is designated for the provision of a drawdown pension and the recipient of the drawdown pension dies. The taxation of any subsequent death benefits is governed by the age of the deceased beneficiary at that time. Following the death of the recipient s immediate predecessor and where the remaining pension fund is paid out as a lump sum, the lump sum will be tax free provided the predecessor dies under age 75 and it is paid within two years of when the scheme administrator could have reasonably known of the death. Otherwise the lump sum would be subject to the special lump sum death benefit charge. It s important to highlight that the age of the member on their death has no bearing on the tax treatment of benefits payable on the second and subsequent deaths. The age of the recipient s immediate predecessor is the determining factor in establishing the tax rate to be applied against the payment of a lump sum. This can best be demonstrated in the following case study. 2

3 Case study John died on 10 January 2015 aged 80 and is survived by his wife and 2 children, James and Laura, both of whom are in their forties. Having left his non pension assets to his wife, he had completed an expression of wish requesting that the scheme administrator consider applying the pension fund for the benefit of James and Laura. As beneficiaries, they requested the provider delay paying death benefits until after 5 April 2015 to benefit from the new pension rules. Both elected to take a beneficiary s flexi-access drawdown, with James drawing income from his fund at his marginal rate of income tax. Laura, on the other hand, took no income and died in March 2016; being survived by her two adult children, Amelia and Jenna. As Laura died under age 75, her daughters could take a lump sum or pension free of tax. Amelia decided to take a lump sum to use as a deposit for a flat, whilst Jenna elected for flexible access drawdown and used the tax free income to supplement her employment income. Lump sum paid to an individual Under the current rules, a non-dependant beneficiary is only entitled to a lump sum. However, from 6 April 2015 they will be entitled to take a pension or a lump sum. Where a lump sum is paid directly to an individual, this removes it from the tax sheltered pension environment. The subsequent taxation of the lump sum will depend on what is done with it. The individual may choose to spend it, gift it away, or invest it. Where the individual spends the lump sum on the likes of holidays, the money immediately leaves their IHT estate. Where the individual chooses to gift the money to another individual, such as to children and grandchildren, this will be a potentially exempt transfer for IHT purposes. This means the value of the gift will fall out of the donor s IHT estate after 7 years. In both situations, the lump sum would ultimately leave the estate of the individual and escape taxation in their hands. Where they choose to invest the lump sum, the taxation will depend on the underlying investment. Income tax Taxable income up to the personal allowance will suffer no tax. The personal allowance is 10,000 in 2014/15 unless the individual is born before 6 April 1948 or their income exceeds 100,000. The basic personal allowance in 2015/16 will increase to 10,600. Income tax rates on taxable income range from 0% to 45% depending on the amount and type of income (see below). 2014/ /16 Tax rate % Tax band % Tax band Starting rate for savings , ,000 Basic rate , ,785 Higher rate 40 31, , , ,000 Additional rate 45 Over 150, Over 150,000 The tax rates on dividends are 10%, 32.5% and 37.5%. 3

4 Capital gains tax Individuals are entitled to a capital gains annual exemption which can be offset against any net chargeable gains in the tax year. Currently this is 11,000, rising to 11,100 in 2015/16. Where overall gains exceed the annual exemption, they will be subject to capital gains tax at 18% where the gains fall within the individual s otherwise unused basic rate income tax band, and 28% thereafter. If the individual invests in ISAs, there will be no income or capital gains tax charges, making ISAs particularly attractive for higher and additional rate taxpayers who fully use up their annual CGT allowance. Inheritance tax ISAs form part of the holder s estate for IHT purposes. To the extent that the underlying ISA investment relates to AIM shares which have been held for at least two years, they will be excluded from the value of the individual s IHT estate. It was announced in the Autumn Statement that following the death of an ISA holder, their spouse/ civil partner will inherit the ISA benefits. Spouses will be eligible to claim an additional ISA allowance where the ISA holder died on or after 3 December Spouses will be able to claim their additional allowance from 6 April Lump sum paid to trustees of a bypass trust A bypass trust is a simple, irrevocable discretionary trust used as a means of holding lump sum death benefits from a SIPP. Rather than being paid outright to a specific individual following the death of a member, the lump sum may be paid to the trustees of the bypass trust. Trustees can use their discretion in deciding who should benefit. There is a wide class of potential trust beneficiaries including surviving spouse, children, grandchildren and so on. The trust can be set up at any time, either at inception of the SIPP or at a later date during the member s lifetime provided they are in good health at the time. It s important to know what taxes will apply once the trustees receive the lump sum and invest it. The trustees are granted wide investment powers within the trust deed. Income tax The trustees will be liable to income tax on any income arising within the trust at 45%, unless it s dividend income. Dividend income is taxed at 37.5%, of which 10% is covered by the tax credit, leaving an additional 27.5% of the gross dividend income to pay. Trustees are not entitled to an allowance exempting income up to a specified amount in the same way that individuals are entitled to a personal allowance. However, the first 1,000 of trust income is taxable at the basic rate of 20% or the dividend ordinary rate of 10%. This enables trusts with small amounts of income to avoid tax liabilities of 45% and 37.5%. Where the underlying trustee investment is a life assurance bond, this is a non income producing asset. There are no income tax charges unless a chargeable event gain arises, such as on the surrender of the bond. Chargeable event gains are subject to income tax. Bond withdrawals may be taken on a 5% tax deferred basis (for up to 20 years) which will not trigger an income tax charge. 4

5 Trustees cannot hold ISAs but may invest in OEICs and unit trusts which are chargeable at the income tax rates applicable to discretionary trusts (45%/37.5%). Any income paid to a trust beneficiary is net of 45% tax. Whilst the trustees are assessed to tax on gross dividend income at 37.5% or 10%, the rate of tax regarded as deducted from payments to beneficiaries is still 45%. The result is that unless the trust has unused tax from earlier years, then it will not be possible to pay out the entire trust fund. Capital gains tax Gains on disposals of chargeable assets by the trustees are calculated in the normal way. The trustees are entitled to an annual exemption of 5,500 for 2014/15 rising to 5,550 in 2015/16. This is equivalent to half an individual s exemption, or proportionate part thereof where there are associated trusts. For 2014/15 onwards, the rate of tax on any remaining gains is 28%. Inheritance tax The value of the trust fund which includes the death benefits doesn t form part of anyone s IHT estate since there s been no outright payment by the scheme administrator to an individual. The potential beneficiaries of the bypass trust have no entitlements to the trust fund. They can only benefit at the trustees discretion. The payment of income from an OEIC to a discretionary trust beneficiary will not give rise to an IHT exit charge, unlike the payment of an investment bond withdrawal. As well as being able to make outright payments of trust money to beneficiaries, the trustees can make loans to them. This may create a debt on the beneficiary s estate reducing the value of their IHT estate, assuming the loan is still outstanding on their death. Advantages of trusts Whilst recognising the importance of taxation there are other reasons that may make a bypass trust attractive and these include: To safeguard capital for children/grandchildren from a previous marriage The value of the trust fund not being assessable for state benefit purposes including long term care Potentially greater protection in terms of safeguarding capital for the member s intended beneficiaries in the event of the death, divorce or bankruptcy of the beneficiary. Instead, the bypass trust is subject to IHT on each 10th anniversary of the trust s creation (called a periodic charge) and upon distribution of capital to trust beneficiaries (called an exit charge). There s a maximum IHT charge of 6% on the occasion of a periodic or exit charge. 5

6 What about James Hay Partnership bypass trusts already set up? Where there s an existing bypass trust there will usually be no nomination by the member in place. This being the case, James Hay Partnership as scheme administrator, can exercise discretion and apply the pension fund to a dependant following the member s death. Dependant is defined under paragraph 15 of Schedule 28 of the Finance Act This includes, though is not exclusive to, a surviving spouse, a child under age 23 and any person who was financially dependent on the member. The dependant is able to choose whether they take a pension, lump sum or annuity. If James Hay Partnership does not exercise their discretion then a lump sum death benefit would be paid to the bypass trust. As well as offering the bypass trust, we also provide a sample letter of wishes that can be used to accompany the bypass trust if appropriate. This letter of wishes is not a nomination but a nonbinding letter from the member to James Hay Partnership. It notes the existence of a bypass trust, however, asks that the scheme administrator, before paying any amounts to the trust, considers a request that all or part of the member s pension fund be paid to a named dependant. Following the dependant s death, any remaining pension fund is to be paid to the bypass trust. So notwithstanding the existence of a bypass trust, it is possible for the member to nominate anyone to benefit from their pension fund following their death. Where a provider s scheme rules might prevent anyone from benefiting from a member s pension fund, or where there is a restriction regarding the form that the pension fund can take, then there is a statutory override within the Taxation of Pensions Act This override enables trustees or managers of registered pension schemes to make certain payments including that of a drawdown pension to a dependant, nominee or successor. Whilst the bypass trust is irrevocable once set up, and cannot simply be set aside for legislative changes, it is not the case that a lump sum death benefit will automatically be paid to its trustees following the member s death. The member is still able to nominate a beneficiary to take advantage of the pension freedoms effective from 6 April James Hay Partnership is in the process of reviewing how the Taxation of Pensions Act 2014 sits in the context of its scheme rules and bypass trust. Any changes required to our scheme rules, forms and literature will be communicated as appropriate. Under the Taxation of Pensions Act 2014, the intention is to allow anyone, not just a dependant, to benefit from a deceased member s pension fund and with anyone being able to benefit from a pension, annuity or lump sum. In other words, the restriction limiting a pension or an annuity to a dependant has been lifted with non-dependants being able to take their pension fund in the form of a pension, annuity or lump sum from 6 April

7 Comment It s important to ask the question of whether there is still a place for the bypass trust, given the changes to the taxation of pension death benefits which will come into force from 6 April Arguably, from a tax perspective, the bypass trust may hold more attraction in situations where the member dies over the age of 75. Regardless of to whom a lump sum payment is made, it will suffer tax at 45%. Consideration, of course, needs to be given to the subsequent taxation where the payment is made to an individual versus a trust. Where the member dies over age 75, an individual beneficiary taking a pension in 2015/16 will pay tax at their marginal rate, so in this scenario taking a pension may still be better tax wise than the tax rate applying on a lump sum payment (45%). As mentioned earlier, it s proposed that from 2016/17, a lump sum payment will be subject to the recipient s marginal rate of tax. Where the recipient is a trust, this would mean that 45% tax would still be deducted from the lump sum, whereas, an individual receiving a lump sum or pension may be a lower rate taxpayer. Whilst the pension death benefit changes coming into force have undoubtedly diminished the appeal of the bypass trust, there are other reasons for having a bypass trust in place. As always, it s a question of knowing what the member would like to happen to their pension fund following their death. Further information Tracyann Kneen Technical Manager Tax and Trusts Please contact the Technical Support Unit with any further queries on: Tax and Trust Technical Support: Please note that every care has been taken to ensure that the information provided in this article is correct and in accordance with our understanding of current law and HM Revenue & Customs practice. You should note however, that James Hay Partnership cannot take upon itself the role of an individual taxation adviser and independent confirmation should be obtained before acting or refraining from acting upon the information given. The law and HM Revenue & Customs practice are subject to change. The tax treatment depends on the individual circumstances of each client. James Hay Partnership is the trading name of James Hay Insurance Company Limited (JHIC) (registered in Jersey number 77318); IPS Pensions Limited (IPS) (registered in England number ); James Hay Administration Company Limited (JHAC) (registered in England number ); James Hay Pension Trustees Limited (JHPT) (registered in England number ); James Hay Wrap Managers Limited (JHWM) (registered in England number ); James Hay Wrap Nominee Company Limited (JHWNC) (registered in England number ); PAL Trustees Limited (PAL) (registered in England number ); Santhouse Pensioneer Trustee Company Limited (SPTCL) (registered in England number ); Sarum Trustees Limited (SarumTL) (registered in England number ); Sealgrove Trustees Limited (STL) (registered in England number ); The IPS Partnership Plc (IPS Plc) (registered in England number ); Union Pension Trustees Limited (UPT) (registered in England number ) and Union Pensions Trustees (London) Limited (UPTL) (registered in England number ). JHIC has its registered office at 3rd Floor, 37 Esplanade, St Helier, Jersey, JE2 3QA. IPS, JHAC, JHPT, JHWM, JHWNC, SPTCL, SarumTL and IPS Plc have their registered office at Trinity House, Buckingway Business Park, Anderson Road, Swavesey, Cambs CB24 4UQ. PAL, STL, UPT and UPTL have their registered office at Dunn s House, St Paul s Road, Salisbury, SP2 7BF. JHIC is regulated by the Jersey Financial Services Commission and JHAC, JHWM, IPS and IPS Plc are authorised and regulated by the Financial Conduct Authority. The provision of Small Self Administered Schemes (SSAS) and trustee and/or administration services for SSAS are not regulated by the FCA. Therefore, IPS and IPS Plc are not regulated by the FCA in relation to these schemes or services.(01/14) JHSTT 03 FEB15 LD 7

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