Tax simplification: lump sums and death benefits examined

The provisions of the finance act relating to the simplified tax regime for pensions are detailed and complex. In an earlier feature we looked at the main aspects of the new system. Now we examine the transitional tax-free lump-sum rules and death benefits more closely to see how they will operate in practice.

No explanatory notes have yet been provided for the new simplified tax regime for pension arrangements. Yet with an effective date of 6 April 2006 ("A-day"), employers have only a relatively short time to get to grips with the new rules and establish the necessary systems to operate them. In our first guidance feature on the topic we examined the main aspects of the new regime. As subsequently pointed out, last minute changes to the Finance Bill mean that minor amendments have had to be made to the flowchart describing the calculation of maximum lump sums.

The latest version of the flowchart devised by Watson Wyatt Worldwide is reproduced in box 1 . Revisions have been made to the top box on the chart to make it clear that lump sums that have already crystallised must be taken into account when calculating members' maximum lump-sum benefits. The chart also reflects the final provisions of the Finance Act 2004 regarding the calculation of the maximum lump sum allowed where the member is claiming primary protection.

More details of the transitional arrangements in respect of lump sums are given below, together with brief details of the new death benefit rules.

Lump-sum arrangements

The new standard limit on tax-free lump sums under the simplified tax regime for all types of pension arrangement is straightforward. From each separate pension arrangement, up to 25% of the capital value of a member's benefits (valued in accordance with the Revenue's statutory principles as opposed to the actual value) may be taken as a tax-free lump sum. Thisincludes any compulsory lump sums as paid, for example, under certain public sector schemes. The maximum permissible cannot exceed 25% of the lifetime allowance (LTA) available to the member at the date of crystallisation. The LTA is to be £1.5 million as at A-day, so the maximum amount of tax-free cash available at that date cannot exceed £375,000.

In many instances the new limit will result in a higher lump sum than is available under the present regimes. If members have pre-A-day rights to lump sums either greater than £375,000, or that amount to more than 25% of the value of their funds, or both, transitional arrangements are available to protect those entitlements.

Transitional lump-sum arrangements

Almost nine pages of Schedule 36 of the Act are devoted to describing the transitional provisions in respect of lump sums.

The basic principles are set out in the flowchart. Where the member's entitlement to a tax-free lump sum before A-day is greater than 25% of the value of the pension fund but less than a quarter of the LTA, there is no requirement to register the lump sum for protection. But it is essential that the scheme maintains records of the calculation of that lump sum to justify its payment. Box 2 illustrates how a member's maximum lump sum would be calculated in these circumstances.

Enhanced and primary protection

If a member registers his or her pension rights for enhanced protection (see Complexity is price of tax simplication  for details), then the proportion of the total benefits that may be taken as a tax-free lump sum is fixed at A-day. This means that the maximum lump sum that may be taken at retirement is the same percentage of the total benefits as the maximum permitted lump sum immediately prior to A-day is to the capital value (determined using statutory principles) of the fund on that day.

Originally the Finance Bill applied this limit as an additional restriction to the amount of tax-free cash that could be taken if primary protection is claimed. That limit was removed during the Bill's passage through parliament. The Bill, as originally drafted, also provided that an individual, who registers for primary protection and is a member of more than one arrangement in respect of the same employment, had to take the tax-free lump sum in equal proportions from each arrangement. That provision was removed before the Bill was finalised and the lump sum may be taken from any one or more such arrangements in these circumstances.

Box 3 gives examples of how the lump sum is determined where the total lump-sum entitlement on the day beforeA-day exceeds £375,00 and pension rights have been registered for primary and/or enhanced protection.

New death-in-service benefit limits

Although this aspect of the new simplified regime has been less well publicised, the Finance Act contains a number of significant changes in respect of death benefits. The current limit on the amount of tax-free lump-sum death-in-service benefit of four times a member's salary (capped in respect of post-1987 members) has been removed. Nor is there is a restriction on the dependants' pension that a scheme may pay.

If a member dies before a benefit crystallises (in most cases that means before it commences to be paid) and before the age of 75, the only limit on the tax-free lump-sum death benefit is the LTA available to the member at the date of death. If the lump sum is expressed to be payable at the discretion of the trustees there will be no liability to inheritance tax, as under the present rules. Any lump-sum death benefit in excess of the LTA will be taxed at 55%. However, whereas on retirement responsibility for payment of the tax rests with both the scheme and the member, on death in service, the recipient will be wholly responsible for payment of any tax due.

Dependants' pensions do not have to be measured against either the member's or the recipient's LTA, but they will be taxable as income. If the amount of a dependant's pension from all arrangements under a scheme is less than 1% of the standard LTA at the date of the member's death, the scheme may commute it for a taxable lump sum, provided payment is made before the deceased member would have attained age 75.

End of five-year guarantees?

While the Act enables schemes in many cases to pay more generous death-in-service benefits than at present, it restricts the payment of lump sums on death after retirement. No lump sums may be paid at all if the member is 75 or over at the date of death. In addition, schemes will no longer be able to pay a tax-free "funeral benefit" of £2,500 regardless of age.

A more common (near standard) benefit under threat is the facility to commute remaining pension instalments on death within a five-year guarantee period. Under current rules, if a member dies within five years of retirement an amount equal to five years' pension, less any pension already received, may be paid as a tax-free lump sum. Unless the member's pension vests before A-day, schemes will not be able to pay the benefit in this form. Mercer Human Resource Consulting has suggested that one way around the problem where members are aged under 70 at retirement would be to insure the guarantee payment as a separate death benefit using a five-year decreasing term insurance policy. If this is done, the benefit is not considered to vest until the member dies.

Watson Wyatt agrees that this is an effective solution, but suggest that this is possible without having to effect separate insurance.

Providing value for money

The Act allows two methods for schemes to provide some kind of pension guarantee. The first is "value protection". If this provision is used, where a member dies before the age of 75, a lump sum equal to the value of the pension put into payment, or the purchase price of an annuity, less any instalments of pension/annuity already received, may be paid as a lump sum with tax at the rate of 35% deducted. If a member dies aged at least 75 and is not survived by any dependants, any alternatively secured pension funds (this is where the money has not been pooled because of religious objections, for example) may be used to increase the benefits of other members or applied towards the scheme's surplus. The funds may also be left to a nominated charity.

The other method to protect value is to guarantee payment of pension for up to 10 years. If the member dies within the 10-year period, the pension would continue to be paid in instalments as a taxable benefit. However, it may not be paid as a lump sum.

At present, understanding of the new tax regime depends on interpretation of the Finance Act, which is not an easy read. The Inland Revenue intends to publish guidance notes next year explaining how it will interpret the new rules. Once this is available schemes will have a better idea of how the limits will be applied in practice.