Wealth Questions - How can 55% tax be attractive?

Are pensions really becoming more attractive for inheritance tax (IHT) planning? I have always thought that building up my pension fund was more attractive than wasting money on life insurance: if I die, my partner would receive a six-figure sum from the value of my retirement savings, free of all taxes including IHT. And, of course, if I don’t die, we get to enjoy the pension.

But following last week’s government announcement on retirement flexibility, FT money tells me that pensions will become the “estate planning vehicle of choice”. However, while there will be no IHT on pensions that remain invested in the stock market, there will be still be a hefty 55 per cent tax charge. This doesn’t sound particularly attractive – what am I missing?

Laith Khalaf, pensions analyst at Hargreaves Lansdown, the financial adviser, confirms that up until the point you draw any pension benefits – and so long as you are under 75 – your entire pension fund would be passed on free of all tax including inheritance tax (IHT). So, yes, a substantial pension fund could take the place of life insurance for someone yet to retire.

But bear in mind that with life insurance you get full cover from day one – rather than the value needing to be built up.

This tax-free status of pensions on early death does not change under the latest proposals.

Also, many retirement savings schemes provide a dependant’s pension, with the income taxed solely at the recipient’s marginal rate, or other death-in-service benefits – so reducing the need for separate life insurance.

However, where you have started drawing on your pension via an income drawdown plan – including taking the tax-free lump sum – or have reached 75, then the residual capital can be passed on but is subject to a tax charge.

Previously, this charge has been 35 per cent on death before age 75 and up to 82 per cent on death after age 75. Under the new proposals from April 2011 there will be just one charge of 55 per cent, irrespective of your age on death.

While this might still sound steep, it is a great improvement for the over-75s – hence the talk of estate planning benefits. Also bear in mind that all the government is trying to do here is recoup the tax relief it has paid on your pension fund, leaving the money you have saved yourself to be passed on to your heirs.

So the size of the tax charge simply reflects the generosity of the tax relief paid on your pension in the first place. The government has estimated that for a higher-rate taxpayer, 55 per cent of their pension fund at retirement is made up of tax relief, hence this level of tax should be charged on death to recoup these monies. The remaining fund can then be passed directly to the beneficiary, without IHT.

A slightly different treatment applies to “Protected Rights”, the money that has built up in your pension as a result of contracting out of the State Second pension (S2P). When you die, these funds must provide a pension income for a surviving spouse or dependant. If no spouse or dependant exists, they can then be paid out as a lump sum. However, these special rules are set to be abolished from April 2012.

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