Pension Scheme Death Benefits – Inheritance Tax Issues

 In Finance & Investments

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On considering how a pension fund death benefit will be treated under the Inheritance Tax rules, it is firstly necessary to establish if the capital arises from a source that is crystallised, HMRC jargon for post retirement, or one that is still in the accumulation phase. It is sometimes further necessary to categorise the source as an occupational pension (employer controlled) or a personal pension (member controlled, even if sometimes employer sponsored).

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What Benefits Might Be Identified?

There are basically 3 types:
  1. Survivor’s pensions for spouses or other legally entitled parties
  2. Lump sum death benefits
  3. Continuing Pensions under a pension guarantee

Factors That Influence IHT Treatment

  • The structure of the scheme, notably whether or not the benefits are held in trust, as will be the most common situation prior to retirement
  • Whether death was before age 75
  • The type of benefit
  • Who receives the benefit and when
  • The source of the benefits, ie what sort of fund or other provider
  • The state of health of the deceased in the years immediately prior to death

General Rules

  • Death benefits paid from a registered pension scheme on death before age 75 will normally be free of any liability to IHT unless specifically paid into the estate (for example in the absence of a member nomination and an unhelpful exercise of discretion by the scheme trustees).
  • On death after 75, where the deceased still has an invested pension fund (called an Alternatively Secured Pension – ASP), IHT will apply if a survivor’s pension is paid to what are described as non relevant dependants or a lump sum is paid. Relevant dependants are spouse or civil partner, children or in rare cases, someone else financially dependent on the deceased at the time of death, perhaps a disabled family member. Payment to the relevant dependants (or a charity) must be made within 6 months of death to avoid IHT on an ASP fund.
  • Annuities or defined benefit scheme member pensions may have death benefits payable on death after age 75 in the form of a spouse pension or remaining guaranteed payment period, but by definition an annuity will have been arranged before age 75, so these payments will not normally enter into an IHT calculation.

Important Exceptions

  • HMRC will, as might be expected, take a hostile view where a pension scheme member who has retained the option to vary their pension income from an unsecured pension fund (commonly called income drawdown) varied their pension income downwards after finding out they have a serious or terminal illness. This is because the now sick person is making a transfer of value in favour of the pension scheme by depriving themselves of income which they previously appeared to need. If at least 2 years have elapsed after a reduction in income and before death, then no HMRC challenge will apply.
  • IHT is also payable on Protected Rights pension fund payouts from defined contribution pension funds on death before retirement where there is no surviving spouse and so the accumulated fund is paid to another nominated individual or the estate. Death benefits specifically relating to Protected Rights will not normally be paid as separate sums by contracted out defined benefit schemes (eg the NHS pension scheme), so the issue will not arise. Death in Service payments from such schemes are quite separate and usually paid from a discretionary trust, also making them IHT exempt. Any payment made under a binding direction, where the trustees have a policy of accepting such a direction, would not be exempt, of course.
  • Retirement Annuity Contracts (sometimes called S226 policies) are a sort of personal pension issued before 1988 and death benefits from these policies are payable to the member’s estate unless a specific trust has been created and the death benefit assigned to that trust.
  • If a pensioner or dependant receiving a contingent pension under a joint annuity dies within a guaranteed minimum payment period for the first pension (usually 5 or 10 years), the sum due for settling the balance of the guarantee will be subject to IHT unless it is paid at the discretion of the scheme trustees.
  • Not all personal pensions are issued under a master trust: there is minority issued in such a way that by default death benefits are paid to the estate. A trust should have been put in place by the pensions adviser in such cases, but that will not always have been done.

Caution Required

 There are various complex pension structures available that push the HMRC pension rules to the limit in an attempt to keep the value of large pension funds within families. These include SSAS (Small Self Administered Schemes), so called “Family Pensions” and using personal pension plans to provide member pensions that are actuarially re-assessed on a regular basis. There are also structures imported from the US in various forms that are alien to our pension system at present and do not fall neatly within the usual tax provisions. Although such variations are still fairly rare, designing ingenious uses of such plans is a growth industry and pension providers may create unpredicted consequences in terms of the taxation of death benefits when they move pension funds between family members on death, apart from tripping over the unauthorised payment rules. If a probate practitioner comes across such a case, taking advice from a highly specialist pensions consultant or lawyer would be prudent.
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