Inheritance Tax and Pension Simplification
OK Iím going to have a go at a Plain English explanation of what the tax people have been saying about inheritance tax and pensions since the Chancellorís Budget speech this week.
The current inheritance tax laws we know and love today came about through the Inheritance Tax Act 1984. In 1992 the Capital Taxes Office (CTO Ė the HMRC department responsible for inheritance tax) confirmed in Tax Bulletin Issue 2 that where pension benefits were deferred and the member subsequently died, a claim to IHT could arise where it could be shown that the memberís decision to defer benefits was taken to increase the estate of someone else. But by way of concessionary practice, even if it could be shown that this was the case, the CTO confirmed that where the death benefit was paid to a spouse or financial dependant, they would not pursue a claim and would normally not pursue a claim if the member survived for two years after the decision to defer.
Before the introduction of Income Drawdown pensions were fairly straightforward. Basically people saved for their pension until they reached retirement age when they used their pension savings to buy an income for life. Another term for an income for life is an annuity, and people were said to Ďpurchaseí an annuity when they retired (they also had the right to take some of their pension savings as tax-free cash rather than spend the whole lot on an annuity and most people do that in real life. In fact the tax-free cash is seen by many as being the real benefit of pension saving).
An annuity is a true insurance product. In effect, by paying a premium for a lifetime income people buying an annuity are insuring themselves against living longer than their savings.
So, the idea of an annuity is that, because we all know weíre going to die, but we donít know when, a large enough group of us can pool that risk and uncertainty so that we all get a certain income no matter how long we live in retirement. Those lucky enough to live to a great old age will obviously get more out of the annuity pool than they paid in, whereas those dying early on in their retirement will get less. Itís a swings and roundabouts thing with winners and losers, where the winners donít run out of cash while theyíre alive and the losers only know about it the day after they die - a time when theyíve got other more important things on their minds like what to do for the rest of eternity and stuff.
There would be winners and losers in a world where annuities didnít exist too, except that in such a world the losers would be alive when they ran out of money late in life, whereas the winners would die with plenty of money in the bank. By and large we all agree that, imperfect as annuities are in many ways, itís better to have them than not.
Now annuities have evolved over time along with everything else in our wonderful world of finance and there are now a wider range of options with such things as annuities that continue to other people and impaired life annuities where large groups of people with shortened life expectancy get together and create a pool of money with different dynamics to a pool of healthier people with better prognoses of life expectancy. In that way people who smoke, for instance, donít have to end up funding the annuity payments of people who donít. And there are all kinds of sub-groups like this that have had the effect of fragmenting the big old annuity pools of the past.
That fragmenting, of course, has led to a rise in the cost of annuities in general because more and more people are selecting who else they want to pool their money with at the time they come to buy their incomes for life when they retire. Costs of annuities have also risen because of a general increase in both the optimum number of years we can expect to be walking the Earth and, much more importantly, the numbers of us reaching that optimum lifespan. Good news all round, but tricky as far as the annuity markets are concerned; fiddly as Hell in fact.
Anyway, things got even more complicated in 1995 when ĎIncome Drawdowní was first introduced. Income Drawdown gave people a further option at the point of retirement. Instead of buying an annuity the new laws offered people the chance to simply draw money from their pension savings every year rather than handing the whole lot over to an insurance company and becoming part of an annuity pool. The idea behind it was to give people a bit more control over the timing of their annuity purchase and in particular to allow people to join annuity pools later in life when they would probably get higher annual payments from an annuity purchase (obviously the amount paid out in a pooling deal is dependent partly on the age that someone buys their annuity as their age would have a direct relationship to their likely level of longevity. Put simply, someone of seventy is more likely to pop their clogs before someone of sixty. That doesnít work out in all cases, of course, but pooling is based on generalities).
Income Drawdown turned out to be pretty popular and has given plenty of people loads more control over their finances later in life, but it always had its limitations. The legislation didnít allow people to keep drawing money from their pension savings for ever and keep putting off the day when they would buy an annuity - the legislation imposed a maximum age of seventy-five on Income Drawdown, at which point an annuity had to be purchased with the remaining funds.
Now, and the point where inheritance tax comes in I suppose, because there was always a requirement to annuitise by the age of seventy-five, the Revenue people have been lenient in the way they have applied IHT to unspent pension pots for people dying while in Income Drawdown mode. The concessionary practice that came in in 1992 was updated so that it continued to apply when Personal Pension Income Drawdown was introduced in 1995 and was again updated in 1999 to take account of the introduction of changes to the pension laws that introduced a fairly recent pension phenomenon that we refer to as Occupational Income Drawdown.
Strictly, IHT should apply on death during Income Drawdown but because of the concessionary practice, the Capital Taxes Office wonít raise a claim for IHT where the death benefits are paid to a spouse, civil partner or financial dependant and normally will not raise a claim if the member survives for two years after the decision to take Income Drawdown.
In a few weeks time, as Iím sure you know, the pension tax laws are in for a major re-vamp. Income Drawdown is being amended. At the same time, the rule that says we have to buy an annuity once we hit seventy-five is being relaxed a bit for people who donít want to pool their finances on religious grounds. For that small minority of people who donít want to secure an income by buying an annuity a new Income Drawdown type of idea called Alternatively Secured Pension (ASP) has been put on the statute books. This has confused us ever since the government guys put it on the table.
A lot of commentators in the industry saw the advent of ASPs as an extension of the current Income Drawdown market enabling people to avoid buying an annuity by age seventy-five and to eventually avoid paying IHT on any unspent pension savings at the end of, say, a ninety-year life. Thatís not what the tax guys intended and thatís why their clarification in the Budget stuff is helpful. What theyíre saying is that anyone going beyond age seventy-five with pension savings that have not been applied to purchase an annuity will have to pay IHT on any money left over if there is no dependantís pension or Income Drawdown continuing.
This makes sense of the other announcement this week from Her Majestyís Revenue & Customs (HMRC). The same logic that said that the age seventy-five annuity purchase rule was dead in the water led many to think that the concessions on the way IHT is applied to Income Drawdown cases where the member dies before age seventy-five would go too. Again, put simply that could have meant that a fifty-one year old man deciding to draw funds under the new Income Drawdown rules (and getting access to his tax-free cash at the same time) could have ended up paying IHT on his unspent pension pot if he was unlucky enough to die before he decided to buy an annuity. That would have been a serious outcome that would have been a real problem for many people and would have stopped many from taking advantage of the new rules that break the link between taking tax-free cash and drawing an income from pension savings (under the new Income Drawdown rules it is possible to draw a zero income from a pension pot). In effect all of the flexibilities that are being introduced could have been outweighed by the IHT considerations and risks associated with advising on such issues. It would have been a nightmare.
The clarification about the proper nature of the ASP idea (itís really is an annuity alternative just for those with genuine religious objections to pooling) has allowed the tax people to reaffirm that the IHT concessions that currently apply to deferred pensions and Income Drawdown will also apply to Income Drawdown and Alternatively Secured Pensions in the new regime after A-Day. This will be done by legislating for the concessionary practice in this yearís Finance Act.
So people will be able to get hold of their tax-free cash in their fifties if they like, go into Income Drawdown with their remaining funds and draw an income of nothing at all (if thatís what they want) right up until theyíre seventy-five and beyond without worrying about the IHT implications of doing that Ė just as long as the death benefits are paid out in the form of income to an appropriate survivor or paid as a lump sum to charity. I think thatís a good result.
If youíd like to you can hit the Treasury website to read the full SP on all this by clicking on the following link:
24 March 2006
HMRC - Tax Bulletin Issue 2 - February 1992
HMRC - †Budget Note 26† - Inheritance Tax & Pensions Simplification, 22 March 2006
HMRC - Regulatory Impact Assessment for Simplifying the Taxation on Pensions - Update, 22 March 2006†
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