My father-in-law is worried about how his daughter (my partner), and his son will be able to meet the inheritance tax (IHT) bill on the assets he leaves to them.
He wondered if the assets in his self-invested personal pension (Sipp) could be used to help pay this tax when he dies. He is over age 75 so has paid the one-off lifetime allowance charge that is levied at that age.
If his Sipp is used to help settle the IHT charge after his death would it be treated as income belonging to his children meaning that they are taxed on this as a one-off receipt at higher marginal rates? Or would the Sipp money be treated as an asset of the estate that is used to pay the IHT liability and not incur income tax?
It would be unlikely that there would be any money left in the Sipp if it is used to settle the IHT. NM
James Jones-Tinsley, self invested pensions specialist at Barnett Waddingham, says:
The use of defined-contribution (DC) pension funds, including Sipps, to assist with the payment of IHT has notably increased since 2010. This is because of changes to pension taxation rules since then and the introduction of a new death benefits pension tax regime in April 2015. For example, there is no longer a legal requirement to crystallise or, in plain English, convert an invested DC pension fund into a taxable pension no later than the attainment of age 75. This means that it is now legally possible to keep a DC pension fund fully invested and uncrystallised – or unconverted – up until death, if there is no financial reason to access the fund.
However, age 75 remains an important point where pensions are concerned for two reasons. There is a test of the value of crystallised and/or uncrystallised pension funds against the individual’s remaining lifetime allowance at age 75 to ascertain if an excess income tax charge arises.
And if an individual dies before age 75, the prevailing value of their DC pension fund can usually be passed to their surviving beneficiaries free of income tax. However, if an individual dies aged 75 or older the death benefits received by the surviving beneficiaries are subject to income tax at the recipient’s marginal rate.
Your father-in-law is over age 75. This means that he has had the age 75 test of the value of his pension benefits against his remaining lifetime allowance. From what you say, it appears that your father-in-law has paid the one-off lifetime allowance charge that is levied when an individual reaches this age. But an excess tax charge is not always incurred at age 75 – it depends on the value of an individual's pension funds at age 75 relative to their remaining lifetime allowance.
You ask whether using the Sipp to settle the IHT bill would result in an income tax charge on your father in law's beneficiaries.
The law allows an individual to leave their pension fund untouched until their death. After your father in law's death, the trustees of his Sipp will arrange the distribution of the prevailing value of his pension fund to his surviving beneficiaries. To assist them in deciding who to pay the death benefits to, your father-in-law should complete and submit an up to date expression of wishes form for his Sipp provider on which he can name his preferred recipients. The contents of this form are not binding on the Sipp trustees but they will play an important part in their decision making. Importantly, because the distribution of pension death benefits is at the discretion of the Sipp trustees, the monetary amounts distributed are not normally subject to IHT.
But because your father-in-law is over age 75 the death benefits are subject to income tax at the recipients' marginal rates. So if his son and daughter are subject to different rates of income tax, and the sole purpose of the death benefits received is to settle his IHT bill, he should consider paying the sum to the child with the lowest rate of income tax. He should get advice on this aspect.
Your father-in-law's Sipp should not be treated as an asset of the estate. If a Sipp is a trust based pension arrangement it is outside an individual's estate for IHT purposes. Including reference to the Sipp in your father-in-law’s will could – at worst – make the value of the Sipp part of his estate for IHT purposes, and its distribution constitute a binding request by your deceased father-in-law on his executors, and therefore potentially subject to IHT.
So your father-in-law should keep his Sipp separate from his estate and tell his son and daughter that he would like them to use his Sipp fund to pay any IHT bill that may arise on his death.
