The main tax consideration here will be Inheritance Tax (IHT) and, to a lesser extent, income tax.
The important thing to remember is that a pension scheme, including a dependent’s/nominee’s Flexi-access fund, is outside the scope of Inheritance Tax. Therefore, you need to consider the options available in the context of how this will affect your client’s personal IHT position. It would appear that the spouse was a member of a Money Purchase (Defined Contributions) scheme.
Taking the tax-free lump sum will increase your client’s personal estate and potentially risk being charged to IHT at 40% whereas leaving funds in the Flexi-access fund will remain out of the estate and can be passed on free of IHT. Although there may be an initial attraction of taking a lump sum or high withdrawals, this could be potentially expensive in IHT terms if the funds remain in the personal estate, whether as cash or converted into personal investments or assets. In addition, in view of the £2m estate cap applying to the Residence Nil Rate Band, the consequences of taking a lump sum or large withdrawals need specific consideration where there is a risk of a personal estate approaching this threshold.
Also remember that income on the Flexi-access fund will be tax-free within the fund, whereas income from personal investments will be chargeable to income tax. Therefore taking a lump sum or large withdrawals for personal investments, would have an income tax cost in addition to the potential IHT cost.
On the death of your client, any remaining funds within the Flexi-access fund can be paid to “qualifying persons” income tax-free if your client died before reaching 75, or charged to income tax at the recipient’s marginal income tax rates if your client dies over the age of 75. See HMRC’s guidance at PTM073600 for more information.
There is no right or wrong decision here but your client should be made aware of the tax repercussions before they decide what is best for them.
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