New legislation has radically altered the landscape for the tax efficiency of inheriting pension funds and individual savings accounts (Isa) after death. We investigate which wrapper is the better option for passing on wealth to your family.
Dramatic changes to the tax burden of inheriting both pension funds and Isas were announced last year by the chancellor. From April 2015 the 55 per cent death tax on pensions will be abolished. At the same time a surviving spouse will be able to inherit a deceased spouse's tax-protected Isa assets via an expanded Isa allowance.
In the past all assets protected under an Isa wrapper while the investor was alive were treated as unprotected assets and liable for income tax and capital gains tax after death. However, in the Autumn Statement the chancellor revealed that from April 2015 a surviving spouse will be allowed to extend their Isa allowance from the new £15,000 level to the amount of their deceased partner's Isa. The rule change is particularly welcome because it allows a surviving spouse to continue receiving income free of tax from their partner's Isa.
The Treasury's original proposal was that assets held in an Isa would be valued at death, before the administration of the estate, and not liable for tax exemption until April 2015, when they can be placed back under the surviving spouse's expanded Isa shelter. However, partners would lose out if the value of the assets held within a deceased spouse's Isa wrapper increase after the date of death, when the Isa assets are valued.
A draft amendment to the legislation has gone further than the original proposal, implying that at some point in the next parliament, Isas could be treated as tax exempt from the period between death and probate. There is currently no way of allowing a tax-free period in probate administration but the draft legislation has laid the groundwork for a direct Isa transfer with no interim period in the following year.
Danny Cox, a chartered financial planner at Hargreaves Lansdown, says: "The period between death and distribution is typically around three months but can be much longer, particularly where an estate is complex involving business or illiquid assets. Extending the tax wrapper during this period makes absolute sense."
The government has also confirmed that Isa assets would be transferrable in specie to a spouse to avoid so called 'bed and breakfast deals' in which spouses would have to sell the assets and reinvest them in order to avoid the costs associated with bed and breakfasting.
Changes to the pensions rules from April 2015 are more complex and are shown in the table below. To summarise, the 55 per cent death tax will be scrapped entirely if you die before age 75; your beneficiaries can spend the money at will with no tax to pay. If you die aged 75 or over, whoever inherits your pension can leave the money in the pension and pay no tax, or withdraw the money and pay income tax on it.
Tax experts at Baker Tilly say the change could lead to families using pension plans as "multi-generational trust funds" where the capital is passed on, untaxed, to future generations, with each generation taking an income from the fund.
Pensions death taxes explained
|Death before 75|
|Old rules||New rules|
|Lump sum||Tax free if passed on before drawing down pension. Liable for 55% tax if passed on after starting income drawdown||Tax free|
|Income||Taxed as income at rate of beneficiary's marginal income tax rate||Tax free|
|Death after 75|
|Old rules||New rules|
|Lump sum||Liable for 55% death tax||Before April 2015: liable for 55% tax; 6 April 2015 to 5 April 2016: liable for 45% tax; 6 April 2016 onwards: taxed as income at rate of beneficiary's marginal income tax rate|
|Income||Taxed as income at rate of beneficiary's marginal income tax rate||Taxed as income at rate of beneficiary's marginal income tax rate|
Inheriting an annuity
If you have taken out a guaranteed term or joint life annuity that leaves a benefit for your spouse or family, and you die before you are 75, then your beneficiaries will not be taxed on either lump sum or income payments. This will apply to annuities where the first payment to a beneficiary is made after 6 April.
If you have a joint life or guaranteed annuity but die after age 75, your beneficiaries will pay their marginal rate of income tax on any payments they receive.
Ben Willis, head of research at Whitechurch Securities, says that pensions are the most flexible and tax-efficient option for passing money down. "Ultimately, you've got to look at the option with the most flexibility and the most benefits and that's a pension," he says. "With an Isa you can only pass it onto your spouse otherwise it is part of the estate. With a pension it can be portable to beneficiaries and they could take the whole fund as a tax-free lump sum."
Unlike pensions, Isas are still subject to inheritance tax (IHT) after death and counted as part of the estate. IHT applies at the rate of 40 per cent on estates worth more than an individual's unused nil-rate band, currently £325,000, or £650,000 for couples.
In future, Isas could transfer seamlessly from one spouse to another but as it stands Isas are protected from both income and capital gains tax but not inheritance tax, unlike pensions, which usually remain separate to the estate and are not subject to IHT.
If the value of the estate falls below the IHT threshold of £325,000, then the Isa will not be liable for IHT, making this an efficient mode of transference. But this is relatively rare and if the total value of the estate adds up to more than that amount the Isa will be liable for 40 per cent IHT compared with no IHT for most pensions pots.
"Isas are still subject to IHT so in terms of tax savings for IHT purposes that's not as efficient as pensions savings," says Philip Haden, a director at independent financial adviser McCarthy Taylor. "Isas are a way to minimise tax but not a way to minimise inheritance tax."
However, there is an exception to that rule surrounding shares traded on the Alternative Investment Market (Aim) for smaller, growing companies. Since a rule change in 2013, investors have been able to hold Aim shares in their Isa portfolios - and these potentially qualify for a double tax break. If held for longer than two years, Aim shares that qualify for Business Property Relief are not counted as part of the investor's estate on death and not liable for income tax. You can read more about this here.
There is also an exception to the rule for pensions. Most modern schemes are exempt from IHT but beware - contracts set up before 1988 and some corporate schemes are taxable on death as part of the estate. There are ways of reversing this, usually by giving the relevant pension board the role of determining the recipients of any lump sums and death benefit nominations being treated as an "expression of wish". Section 226 schemes are also not based on trust, although they can be placed into trust during your lifetime in order to avoid being hit with IHT at a later stage.