Pensions and Inheritance Tax (IHT)
Introduction
This briefing sets out the IHT treatment of pension scheme death benefits and the importance of member nominations.
Core considerations
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Pension scheme death benefits can be paid in several forms and both before and after retirement.
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In most cases pension scheme death benefits (whatever their form or timing) are free of IHT because the trustees or scheme administrator have discretion and choice over who they pay the benefits to.
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In some limited circumstances a pension scheme does not have a choice in relation to death benefit payments. These payments will be included in the estate for IHT purposes unless they qualify for an alternative IHT exemption.
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HMRC may also decide that there has been a transfer of value for IHT purposes if certain events happen within two years of the date of death. These events are reportable to HMRC to investigate and so there may be IHT charges arising in these circumstances.
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Beneficiary drawdown allows inherited pensions to remain outside of the beneficiary estate.
Contents
- Are pension death benefits subject to IHT?
- When might death benefits be assessable for IHT?
- Drawdown death benefits
- Transfer of value during the member’s lifetime
Are pension death benefits subject to IHT?
Pension death benefits can be paid in different ways - for example a lump sum, annuity or drawdown, and either before or after the deceased member has drawn retirement benefits.
Irrespective of these variables the general principle is that where death benefits are payable at the discretion of the scheme administrator and/or trustees, they will not form part of the member’s estate and so will not be subject to IHT.
This will be the case even if death benefits are payable to an individual nominated by the member, provided that the scheme administrator or trustees chose to pay to that individual and were not obligated to do so.
When might death benefits be assessable for IHT?
When there is no discretion in allocating death benefits then pension death benefits will form part of the member’s estate for IHT. On these occasions if other exemptions do not apply (for example the spouse’s IHT exemption) and the estate exceeds the available IHT nil rate band(s), IHT may be payable. This may happen in three specific circumstances:
- Where the scheme rules do not provide discretionary powers in relation to the payment of death benefits
This can happen in some occupational pension schemes (for example some statutory pension schemes such as the NHS Pension Scheme). Some older personal plans such as Section 32 buy out plans and retirement annuities may also not have discretionary death benefit powers. However certain trusts may facilitate removing the death benefits from the estate and may be a solution for some clients.
- Where continuing guaranteed period annuity payments are not paid at the discretion of the scheme administrator/trustees
If Sam dies four years after taking out a pension of £12,000 per annum increasing at 3% in payment with a 10-year guaranteed period, the pension that would have been payable to Sam will continue to be paid for the remaining six years. If the annuity provider/scheme still has discretion over who the payments are made to then these payments do not count for IHT purposes. If, however, there is no discretion (so payments must be made to the estate or following Sam’s specific instructions which can’t be varied) then these payments will form part of Sam’s estate and may be subject to IHT.
HMRC has provided an IHT guaranteed annuity calculator to work out the estimated market value of guaranteed annuity payments when valuing the deceased’s estate.
- Where a binding nomination directing who should receive death benefits is made by the member during their lifetime
This removes the choice the scheme administrators or trustees have in terms of death benefits so brings them within the deceased’s estate for IHT purposes. It is for this reason that schemes generally do not offer the option of making a binding nomination unless there are no IHT consequences (i.e. death benefits payable to a bypass trust or to a member’s spouse or civil partner). However, it is technically possible that a nomination is made binding unintentionally.
Drawdown death benefits
Drawdown death benefits may mean that the scheme administrator has no option but to follow the member’s nomination. For example, if there are no other dependants and the sole dependant has been named by the deceased as being entitled to death benefits. In these circumstances even if the scheme pays flexi-access drawdown benefits to the dependant, HMRC takes the view that the scheme administrator has the option to pay an alternative benefit (for example a lump sum) and can decide who receives this alternative benefit. This means that the member is not treated as having made a transfer of value on death so there is no IHT consequence.
Transfer of value during the member’s lifetime
Making a ‘transfer of value’ during the member’s lifetime means that the value is counted towards the deceased’s estate on their death under IHT legislation. HMRC may treat a transaction as a transfer of value if the member was in serious ill-health at the time the transaction was made so it does not benefit from the general protection that the IHT legislation offers.
HMRC assesses this by applying a two-year test by looking for specific transactions in the last two years prior to death which are captured on their form IHT 409.
There are three areas that HMRC will look at:
- Where a pension contribution was paid and the member knew they were in serious ill health
For example
Archie, aged 61 and knowing he is in serious ill health pays a pension contribution of £25,000 to his personal pension plan with discretionary powers in relation to death benefit payments. Archie dies 10 months later. When he made the contribution a transfer of value took place, there is no exemption under IHT legislation because he knew he was in serious ill health at the time. This means that part of this contribution will give rise to a loss to his estate which can be assessed, and this loss will be a chargeable lifetime transfer.
If, at the time of making the contribution, Archie did not know he had health issues even if he died 10 months later then the exemption under IHT legislation should apply.
Alternatively, if Archie survived for two years after the contribution was paid then no entry would have been made on HMRC’s form IHT 409, so it is unlikely to be investigated by HMRC.
- Where transfers are made between one scheme and another
HMRC takes the view that the person making the transfer is surrendering their rights under the existing plan and so ends any existing trusts that apply to those death benefits. This in turn means that the member can determine what new trusts the death benefits are subject to.
So, HMRC may well treat this as a transfer of value if the transfer had happened within two years of the date of death and the member was in serious ill health when making the transfer. This applies even if a pension transfer was between two schemes that both provide discretionary death benefits. Again, these circumstances would need to be reported on HMRC’s form IHT 409.
If, at the time of making a transfer there were no health issues, then even if death occurs within two years the transfer should be exempt from IHT.
- Where a transfer is made into a trust during their lifetime
This might happen where someone with a retirement annuity places it in trust and then dies within two years of doing that. These circumstances are reportable on HMRC’s form IHT 409 and if the member was in ill health at the time of transferring into a trust, then they may be considered to have a transfer of value for IHT purposes.