Why are the rules and the planning opportunities when designating children as beneficiaries of death benefits of a pension? Jessica List, pension technical manager, Curtis Banks looks at what’s needed to get the best solution for the individual circumstances.
As I was trying to find a sentence to start this article about having children as beneficiaries in defined contribution pensions, it occurred to me that there are several definitions of ‘children’ in this context.
Of course, many people name their children as beneficiaries – but in many cases those individuals will be adults, who may be near or at retirement themselves. Normally when we think of ‘a child’, we’ll be thinking of the definition relating to the age of majority – in other words, someone who is under the age of 18. However, in pension terms there is also a third possibility: HMRC’s definition of a ‘dependant’ distinguishes between children of the scheme member who are above or below age 23.
Unfortunately there’s no way of writing about this topic without using all three definitions, and I’ll try to keep things as clear as possible. I’m primarily looking at the options and considerations for naming under-18s as beneficiaries, and I’ll refer to them as minors.
Before the pension freedoms, relatively few people named minors as beneficiaries. If the minor in question wasn’t a child of the member, they would only be able to withdraw a lump sum death benefit, and many people did not want to leave significant sums directly to minors. Even if the minor was the member’s child and could therefore go into dependants’ drawdown, a quirk in the rules at the time meant that benefits normally needed to be exhausted before their 23rd birthday. This could severely limit the scope of any planning opportunities, and could result in the beneficiary paying significantly more income tax than if they’d been able to spread the payments over a longer time.
By late 2016 these issues had largely been resolved. The quirk was fixed, so that if a child goes into dependants’ drawdown, they will continue to be classed as a dependant even after turning 23, and can therefore continue to take income. The pension freedoms changes also meant that beneficiaries other than dependants could normally have the option of drawdown as well. As a result, more people began to consider the planning opportunities for naming their young children and other minors as beneficiaries. For example, if the death benefits will be subject to income tax, someone might consider leaving the benefits to their two grandchildren with no other earnings, rather than to their child who is already a higher rate tax payer.
Minor as beneficiary
But what actually happens in practice if a minor is chosen as a beneficiary?
Firstly, it is still possible to pay lump sum death benefits to minors, and in some cases, it may still be the only option available. It’s worth checking with individual providers about any particular requirements though. For example, would the provider be willing to pay the funds into a parent or guardian’s account, or would the lump sum need to go to an account in the minor’s name? If the funds are going into an account in the minor’s name, another consideration may be the age at which the minor would have full control over the funds.
As mentioned, savers may consider naming minors as beneficiaries with the intention of them going into beneficiaries’ drawdown. Normally, this will involve a parent or guardian signing the paperwork and acting on the minor’s behalf until they reach 18. Providers will sometimes follow the same requirements and restrictions that they have in place where a normal pension is opened for a minor – again, it’s important to check with the provider in question to make sure there are no unexpected surprises.
It’s worth bearing in mind though, that once the minor reaches 18 they will have full control of the beneficiaries’ drawdown account. Accounts set up since 6 April 2015 will be in flexi-access drawdown, so there’s no limit on the amount of income that can be withdrawn at any one time.
Using a trust
As an alternative, savers are still considering trusts when they wish to leave money to a minor.
Of course there are differences to consider: if death benefits are paid to a trust, then the potential tax advantages of the pension wrapper no longer apply. However, if the death benefits are taxable and this was a key consideration, it’s worth remembering that while the tax situation for trusts is far from straight forward, the complexity can be to the beneficiary’s advantage.
Where a taxable lump sum is paid to a trust, the 45% ‘special lump sum death benefits charge’ is deducted by the pension provider and paid to HMRC. However, when a payment is made from the trust to an underlying beneficiary, the beneficiary can reclaim the 45% charge, and then pay income tax on the gross amount. This should, broadly speaking, put them in the same position as if they had received a taxable payment directly from the pension.
It’s not an ideal process to have to go through, and the beneficiary may well require assistance to make sure it’s done correctly. However, where a person wants to leave funds to a minor but is concerned about them having full control over the money at a later date, a trust can alleviate that issue without too much of an effect on the tax position for the beneficiary.
As with all things relating to death benefits, the rules are very flexible and allow huge scope for planning opportunities. Where a client is considering a minor as a beneficiary, it will be important to balance factors relating to the legislation, the provider’s (or providers’) requirements, and the individual situation to come up with the best solution for the circumstances.