We recently published an article explaining the new rules concerning death tax on inherited pensions from April 2015. The changes mean that when a pensioner dies after 75, beneficiaries drawing down lump sums or an income from the pension will have to pay income tax on both but not the 55 per cent death tax which previously applied to the lump sum.
However, IC reader Jeremy Prescott is still confused. "I am fed up with seeing that 'Old Rules/New Rules' table, accompanied by discussions that never explain the detail of the new rules. If something looks too good to be true, it probably is," he says.
Are there restrictions on beneficiaries?
Mr Prescott wants to know whether there are restrictions on who he can count as a beneficiary. He asks: "Can the beneficiary be anyone, for example my granddaughter, or does it have to be someone who would naturally benefit from a pension, for example a spouse or a dependant relative such as a child under 18 or in education?"
A Treasury spokesperson says: "Under both the current and old system, on the death of an individual aged 75 or over, a lump sum death benefit can be paid to any beneficiary, not just a dependant."
The change comes when drawing down money gradually. The Treasury spokesperson explains: "Currently, if someone dies 75 or over, only a dependant is able to use the drawdown to take the money gradually, paying tax at their marginal rate. The changes will mean any beneficiary will be able to draw down, paying tax at their marginal rate."
“You nominate a beneficiary when you set the plan up and that can be anyone,” says Laith Khalaf, senior analyst at Hargreaves Lansdown. “If you die when the plan is open then the trustees ultimately have discretionary control over who it’s paid to but they will go by who you have nominated,” he says.
Will the income or lump sum counted as income for tax purposes?
According to the new rules, beneficiaries will be taxed at their marginal income tax rate if they draw down a lump sum or income from an inherited pension. "But will their tax rate be calculated before or after inheriting the money?" asks Mr Prescott.
The good news is the inherited pension sum will not count towards income until your beneficiary starts drawing money down from it. However, after that point, drawing down a large lump sum or income could potentially push them into a higher tax bracket.
For example, if you passed down a £200,000 pension pot, it would not affect your beneficiaries' tax liabilities as long as they did not draw anything from the scheme in that tax year. However, if your beneficiary, for example, on an income of £40,000 drew £10,000 down either as a lump sum or income he or she would be pushed from the basic rate 20 per cent tax band into the higher-rate 40 per cent tax band and will have to pay income tax accordingly. In the 2014/15 tax year, most people start paying higher rate tax on income over £41,865.
Patrick Murphy, the managing partner of Zen Wealth says: “If you were a basic-rate taxpayer before drawing anything but drawing an income or lump sum moved you into a higher rate, then some would be taxed at basic rate and some at higher rate."
