This week, we have a guest blog from Daniela Silcock, Senior Policy Researcher at the Pensions Policy Institute.
The Chancellor announced at the Conservative Party conference that changes would be made to the way that Defined Contribution (DC), (money-purchase) pension savings left as inheritance would be taxed.
The current tax rules on DC pension savings are part of a set of tax rules designed to encourage people to use their DC savings to purchase a secure retirement income. However, much of the tax structure supporting this policy is being dismantled as a result of the announcement in Budget 2014 that from April 2015 people will be able to freely access DC pension savings from age 55.
Under current rules, inherited DC pension savings are tax-free if the fund-holder dies under the age of 75 without taking any savings out. Otherwise, they are taxed at 55% (or the beneficiary’s marginal rate if the beneficiary is a spouse or child).
The Chancellor’s latest proposal means that from April 2015, inherited DC pension savings will be tax-free if the fund-holder dies before age 75 and taxed at the beneficiary’s marginal rate if the fund-holder dies over age 75 and the beneficiary draws the income down incrementally.
While on the face of it this appears to be good news, very few people are likely to have very large amounts of pension savings remaining at the end of their lives. The majority of people reaching retirement with DC pension savings have quite small pots, around £20,000 on average and it will be many years before automatic enrolment changes this significantly.
The new tax rules may encourage people to leave their savings in their fund or invest in income drawdown, in the hopes they will be able to leave some as inheritance, rather than purchase an annuity. This could be positive for people who have large levels of savings and other income and assets to support themselves in retirement. However, for people, such as those with disabilities who are eligible for higher rates, or those with low levels of saving, purchasing an annuity could be beneficial and provide the security of an income for life. Leaving a small amount of savings in a pension fund or investing it in drawdown could expose the fund to market risks which people who have small amounts of saving may not be able to afford.
The changes to the tax rules further break the link originally set up between DC pension savings and provision of a secure income in retirement. While greater freedom and flexibility is beneficial for some, for others who are dependent on their DC pension savings to provide an income in retirement these changes could be a motivation to manage their savings in a less secure way.
 DC pension savings can be left as a bequest if they are still in the pension fund or if they are in an income drawdown product which allows people to “draw down” an income while investing the remainder of the fund in the market. DC pension savings used to purchase an annuity cannot be left as a bequest, though annuities can be bought with “guarantees” of an income for designated dependents on the death of the annuitant.
 If the beneficiary takes the total inheritance as a lump sum (and the fund-holder dies after age 75) the inheritance will be taxed at 45%, though the Government intends to change this so that lump sums will be taxed at marginal rate from 2016/17.