Where inheritance tax applies to pensions
26 January 2019
Pensions are normally exempt from IHT. This article from the Prudential technical team, explores those areas where pensions can have IHT implications.
These articles are for UK financial advisers and paraplanners only.
Potential impact of IHT on pensions
It is often quoted that inheritance tax (IHT) does not apply to pensions. But there are instances where it can and does apply. So this article looks at the IHT issues surrounding approved pensions arrangements.
For pension planning strategies linked to IHT, see the Pensions and Inheritance Tax Planning article
Contributions to a pension scheme
Contributions to a pension scheme are not usually lifetime transfers of value for the purposes of IHT, and will be immediately excluded from the member’s estate.
There are however two caveats to this.
1. Where the death benefits from the pension are outside of the estate and the payor is in ill health
If the contributions are made while the member is in good health there will be no transfer of value. But if made while the member is in ill health, there may be a transfer of value.
The underlying principle is that where the member is likely to survive to take their retirement benefits then the payments are for their benefit so are not transfers of value.
It is accepted practice that contributions made more than two years prior to death are not transfers of value.
Reference: IHT Manual – IHTM17042 & IHTM17043
2. Where a contribution is made to someone else’s pension, as the benefit will be for another
These would be a lifetime transfer of value. IHT wise they would either be exempt, possibly under the annual exemption or normal expenditure out of income rules, or potentially exempt.
Further information on transfers of value are in the IHT articles.
Reference: IHT Manual – IHTM17044
There are three ‘death’ related areas where pension funds could be subject to IHT.
1. Payments forming part of death estate
• where the member’s estate has a legal entitlement to have the value of the death benefit paid to it then the death benefit would form part of the member’s estate. This would arise, for example, where a retirement annuity contract was held where the death benefits had not been assigned into a trust.
• any outstanding guaranteed payments from an annuity that are payable to the estate or paid at the annuitants direction are included in the estate for IHT purposes (see IHT and annuities below).
• any arrears of annuity payable to the member on death would also form part of their estate.
Reference: IHT Manual 17051 to 17056
2. Lifetime transfers of death benefits
This can occur when death benefits are assigned into trust and potentially where there is a transfer between pension schemes.
Where the member is likely to survive to take their retirement benefits ie the death benefit will lapse, then the transfer of value would be nominal. However, if a transfer is made whilst in poor health then the value could be more substantial.
Like contributions, in the absence of any evidence to the contrary HMRC would assume that the transfer happened whilst in good health if the period until death was greater than two years.
This principle could also apply where a transfer of benefits is made from a scheme with no discretion / payable to the estate, to one that did have discretion.
HMRC consider transfer of benefits from one scheme to another to be transfers of value. This is down to the fact that the member could direct that the transfer is made to an arrangement where the estate would be entitled to the death benefit.
Like most other things the good health / two-year rule applies. There is a grey area / absence of case law to give an idea of what any transfer of value would be. HMRC will review each case individually taking into account its specific circumstances. The transfer of value may be nominal, or even exempt, but could be substantial. The case study below gives an example of how a transfer might be dealt with.
The basis for calculation is the loss to the transferor’s estate by virtue of section 3(1) IHTA 1984. As such we need to calculate the transfer of value from the transferor’s estate as it is this transfer of value that will drive the IHT consequences. In broad terms, it is the difference in value of the death benefits and retirement benefits in the receiving scheme.
Finally, whilst the member retains the right to retirement benefits there are no ‘gift with reservation’ issues that would otherwise normally arise where gifts are made and entitlement to benefit from the gift remains.
Reference: IHT Manual 17070 to 17074
The IHT manual doesn’t give any guidance. HMRC have however given an indication of how the calculation does take place.
Rights “before” the transfer
This is the open market value of the death benefits which could have been directed towards the member’s estate. This is slightly confusing as it isn’t the rights which there would have been if the member had stayed in the ceding scheme. Instead it is the transfer value ie the death benefit in the receiving scheme. Growth is applied to the death benefit amount and a deduction is made for the period that the member is likely to survive and this then gives the open market value. So, the deduction is calculated using both a growth rate and a discount rate.
“After” the transfer
This is the open market value of the pension rights available after the transfer, again, in the receiving scheme. This has traditionally been calculated using PCLS plus a 10-year guaranteed annuity. However, this valuation basis will be impacted with the introduction of pension freedoms and the change to full access. In principle, this amount should now be the amount of an uncrystallised funds pension lump sum (UFPLS) less what the tax payable would be on a full withdrawal. HMRC have indicated this is the case, however, a case will need brought to tribunal to test the valuation basis.
Hypothetical case study
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