What are your options when you inherit a SIPP?

One of the many reasons why then-Chancellor George Osborne’s 2015 pension shake-up was seen as such a big deal by industry pundits was because it made pensions inheritable.

Up until that time, most people either had a salary-related pension or used their pension savings to buy an annuity that would pay out an income as long as they (and their spouse, if it was a joint annuity) lived.

Either way, when both partners had died, that was generally the end of the pension as far as younger generations were concerned.

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The 2015 regime changed all that. Under those rules, anyone with an investment-based (defined contribution) pension pot - whether or not they have started to draw an income from it - can bequeath it to one or more beneficiaries when they die.

Better still, because pensions are structured as a kind of trust, they don’t count as part of the pension holder’s estate, and therefore are not potentially liable to inheritance tax at 40%.

Indeed, if the owner dies before age 75, the pension passes on entirely tax-free; on death after 75, the recipient of the pension pays income tax at their highest rate when they access the fund.

As you might imagine, this change of rules sent financial planners into paroxysms of excitement as they conjured new ways to help clients pass their wealth down the generations.

As financial advisory firm Forvis Mazars explains: “A common strategy in recent years has been to withhold drawing from pension funds, and draw on other, less tax-efficient assets that will be subject to inheritance tax (IHT) instead.”

In other words, where possible, it makes sense in IHT terms to use final salary pensions, taxable savings and individual savings account (ISA) capital before touching your pension. The aim here is to leave as much as possible in that tax-efficient wrapper outside the estate for younger generations.

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Going forward, however, as salary-based pension schemes dwindle and people become increasingly reliant on income drawdown from investment-based pensions, it’s likely that the next generation will tend to inherit active drawdown accounts rather than untouched pension pots.

So, if you do find yourself in that position, what choices are open to you as to how you manage your windfall?

In most regards the options are much the same as if the pot had not been accessed, but there are some differences. Either way, as discussed above, your tax position will depend on the age at which the original pension holder died.

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Importantly, inherited pension or drawdown does not count towards your own “lump sum and death benefit allowance” (LSDBA, replacing the old Lifetime Allowance).

Once the pension provider is notified of the death, you have a two-year window in which to ensure the account is re-registered in your name; you’re then free to use it as and when you want to.

1) Take a lump sum

You could take the contents of the drawdown account (or some of it) as a cash lump sum. As Ian Cook, a chartered financial planner at Quilter Cheviot, points out: “This provides immediate access to the entire amount, freeing you up from any further management responsibilities. You can use the funds as you see fit, whether to pay off debts, make a significant purchase or invest differently.”

However, if you take this route, you remove the potential for future investment growth or income in that tax-protected pension wrapper, so there is little point in cashing in the account simply to hold it in a deposit account.

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Additionally, there may be tax implications. If the deceased was under 75, your lump sum will be tax-free, but if they were older, the money will be taxed as income and could push you into a higher bracket.

“This route may be best suited for those who need immediate funds, perhaps to repay a mortgage or other debt, and are potentially in a lower tax bracket or can plan carefully to minimise the tax impact,” suggests Cook.

2) Buy an annuity

An alternative is to use the money in the drawdown account to purchase an annuity that will pay you (and a spouse, if you buy a joint annuity) an income for life. Again, you may pay income tax on the withdrawal, depending on the age of death of the original account owner.

“This option is ideal if you’re seeking financial stability through a guaranteed income, especially if you prefer low-risk solutions and do not wish to manage investments,” Cook observes.

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The attractions of this route are likely to increase the older you are, given that annuity rates become more attractive with age and declining health. Cook adds that if you have other income sources to live off in the meantime, it could therefore make sense to leave the money invested for a while (see option 4 below).

3) Draw an income from the account

If you’ve inherited a drawdown account, it’s likely to be invested so as to deliver a sustainable income. You could therefore just “turn on” this income stream in your own name, leaving the capital invested and potentially growing over the longer term.

While that income may not be tax-free because of the age of death, tax is only payable on withdrawals from the account, so you can adjust the amount you take so as to avoid pushing yourself into a higher tax bracket.

Importantly, you can take an income from an inherited pension even if you are less than 55 years old - the age at which you’re currently allowed to access your own pension pot.

Says Cook: “This route requires ongoing management and careful financial planning to avoid depleting the pot prematurely. It will suit those comfortable with managing investments or with access to financial advice, as it’s no mean feat getting the balance right between income and potential growth.”

4) Leave the pot invested for later

Many people who are earning enough through their job, or who already have sufficient pension income, might well decide to leave their inherited pension invested. If there’s no need for income generation at present, they may prefer to make use of growth-focused funds at this stage.

Not all providers of income drawdown accounts make such funds available, but you may be able to transfer the account to one that does. Online brokers catering to self-guided private investors, such as interactive investor, typically offer the full range of funds and investment trusts for investors in drawdown, as well as for those building up pension pots.

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As Cook observes: “This strategy offers the potential for continued investment growth and the flexibility to start taking income or lump sums at a later date.” Again, though, you’ll need either to be happy managing your own investments or willing to pay for professional advice.

5) Pass the whole thing on to your children

If you are well provided-for and the pension pot is clearly surplus to your lifetime requirements, it may be possible to “skip a generation” so that it goes straight to younger members of the family.

However, Cook warns that not all pension schemes will allow such a move.

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Moreover, some forethought is needed. A will does not normally stipulate what should happen to a person’s pension, as it’s not considered part of their estate, so the original pension owner needs to nominate the beneficiaries on a death benefit nomination form (also known as an expression of wishes). This is used by the trustees in allocating the pension after death.

“The only alternative, if the death benefit nomination form is not completed but you don’t require the funds yourself, would be to draw them down and make a gift from your own estate,” Cook says. “But be careful, as that gift will remain in your estate for seven years under current inheritance tax rules.”