Technical: Passing wealth down the generations
21 August 2017
Fiona Tait, technical director, Intelligent Pensions looks at the ways that paraplanners can help baby boomer clients pass on their wealth tax efficiently.
A key issue for financial planning is how to help baby boomer clients pass on their wealth to their descendants without giving the majority away in taxes.
There are a number of options available involving gifts from income, potentially exempt transfers and trusts but one of the simplest and most effective ways is to use the death benefit options available under defined contribution (DC) pension plans.
Let’s take a client who has just been presented with their first grandchild. There are 3 ways within this scenario that the client could pass their DC pension benefits to the new grandchild, depending how quickly they want them to have it and how much they trust other members of the family to act in their best interests:
1. Nominate the grandchild to receive some or all of the fund in cash immediately upon their death
2. Set up a trust to receive the cash death benefit and include the grandchild in the list of potential beneficiaries
3. Use Flexi-Access Drawdown (FAD) to pass benefits via one or more intermediate beneficiaries.
Option 1 – individual nomination
The advantage of this route is that the grandchild will benefit immediately following the member’s death. If the client is satisfied that their spouse and any children are financially secure they may decide that skipping a generation is more efficient than adding to the estates of closer family members. Instead of, or in addition to, nominating the most obvious individuals – spouse or children – the client fills out a new expression of wish naming the grandchild as their preferred beneficiary.
This approach would be less beneficial if either the spouse or children are not suitably provided for. Firstly (and obviously) because the client is unlikely to want their nearest and dearest to suffer hardship, and secondly because the payment of death benefits is subject to trustee discretion. The trustees will usually follow the member’s wishes when paying death benefits but they do not have to, and while it is not common for them to choose a different beneficiary it is most likely to occur where another family member feels strongly enough to make representation to them for a fair share.
This situation could of course be overcome by giving the trustees a binding direction, assuming the scheme rules permit it, however this would mean benefits becoming part of the estate on death, potentially resulting in inheritance tax (IHT). We will therefore assume the client does not do this in any of our 3 scenarios.
A final point is to ensure the client regularly reviews the nomination and does not forget to include any more grandchildren that may come along.
Option 2 – bypass trust
The clear advantage of this route is that a particular beneficiary, usually the spouse, may receive payments from the proceeds of the pension fund but does not have control over the final destination of any remaining monies. This is especially useful where the member has been married more than once.
This is done by creating a discretionary trust with trustees appointed personally by the member. In the event of the member’s death the pension fund is paid to the new trust which includes the spouse as a potential beneficiary. The trustees may then make payments of capital or income to the spouse as long as they need them (in many cases this is done in the form of a loan, which creates a debt on the spouse’s estate to reduce IHT). On the death of the spouse the trustees distribute the trust property to the other beneficiaries in accordance with the member’s wishes. This is usually the next generation (children) but the member could ask the trustees to pay benefits to the grandchild as well or instead.
However, discretionary trusts are subject to unfavourable taxation treatment compared to pension funds and Option 3 is being increasingly adopted for that reason.
Option 3 – Flexi-Access Drawdown (FAD)
In this scenario the capital remains in pension pots that can be cascaded down the generations:
1. The member nominates their chosen beneficiary, often the spouse, who elects to receive it as dependants’ (or nominees’) FAD rather than as a cash payout.
2. The first beneficiary (spouse) in turn nominates the next beneficiary(ies) to receive any undrawn funds after their death.
3. They in turn would elect to inherit their share as successors’ FAD pots, and in turn nominate the next set of beneficiaries. And so on.
The advantage of this route is that each generation benefits in turn from the favourable tax treatment of holding capital within pension funds, which are tax exempt for income and gains and also remain outside of their estates, avoiding potential IHT. This is an incredibly tax-efficient process, especially if any of the parties die before age 75, however it relies not just on trustees discretion but also the good intentions of each succeeding beneficiary to pass the money to the next party. Probably not the best option where there are competing interests or a well-known spendthrift in the family.
In summary, it is possible to pass pension funds from baby-boomer direct to baby, but there a number of options available to ensure the previous generations get their share.
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