IHT and the pension transfer window

Generally speaking, trustees and scheme administrators have discretion over the distribution of death benefits from a pension scheme. This is important as it means that the benefits can usually be paid free of any Inheritance Tax (IHT).

The reform to the taxation of death benefits and the record £4.6 billion IHT revenue that HMRC took last tax year have, however, brought the issue of transfers and IHT to the fore.

If a client makes a transfer whilst knowingly in ill-health then there is a risk that HMRC will challenge the IHT-free status of the death benefits should the client then unfortunately pass away within two years of the transfer.

Although advisers are generally well aware of the risks, we are often asked how HMRC would know about any transfers and how they would calculate any ‘transfer of value’ for IHT purposes?

As part of the probate process, the personal representatives of any deceased clients who held or received any pension (excluding state pension) will need to complete an ‘IHT409’ form. The ‘transfer of value’ calculation is not quite as simple as taking the value of the pension benefits transferred. It is useful to understand the legal background here, as it helps to explain HMRC’s thoughts when considering the issue.

There are theoretically two mutually-exclusive sets of rights under a pension scheme - the ‘lifetime pension benefits’ and ‘death benefits’. The death benefits can only be paid if the lifetime pension benefits have not been paid. By the same token, any payment of lifetime pension benefits will reduce the amount of death benefits available.

HMRC assesses the ‘transfer of value’ made by a client in ill-health within two years of death as the difference between:

Amount 1 - the open market value of the transferor’s rights before the transfer; and

Amount 2 - the open market value of those rights after the transfer.

This establishes the deemed ‘loss’ to the individual’s estate as a result of the transfer.

We spoke to HMRC to establish the steps they would typically take to calculate the above using our fictional client, John.

John has a SIPP valued at £500k and a life expectancy of 18 months. He makes a full transfer to another SIPP but unfortunately he dies six months later.

Amount 1

Whilst the transfer does not mean that the pension fund becomes part of the estate during the transfer itself, the theory begins with the fact that John could have directed the death benefits from the SIPP into his estate (however unlikely in practice). The starting value would be a £500,000 lump sum with a discount representing an 18 month delay until the death benefits were expected to be paid out to give us the maximum open market value.

A growth and discount rate is applied which is based on the amount of time before the transferor’s expected date of death. This commonly works out as an overall discount rate of 7.5% p.a., reflecting the rationale that the estate has been deprived of the value of death benefits that could have been payable to it on the death of the transferor.

Assuming the overall discount rate of 7.5% p.a., the starting value might be around £448,500.

Amount 2

The maximum value of the lifetime pension benefits payable after the transfer was historically based on the maximum PCLS payable plus a ten-year guaranteed annuity. With pension freedoms, this might be based on what the transferor could have received as a PCLS plus single, taxable lump sum, minus the Income Tax that would have been paid.

Let’s assume an annuity rate of 5% for a ten-year guaranteed annuity. In terms of lifetime pension benefits, John could have received a PCLS of £125,000 from his £500,000 fund. The remainder could have been used to buy an annuity of £18,750. In total, this would have paid out £187,500 (i.e. £18,750 x 10), despite his early death.

To reflect the fact there would be a deduction of Income Tax on the annuity payments as well as a ten-year discount on the value of the income stream, the open market value of the annuity could be around £82,600, giving a total value of £207,600 (i.e. £125,000 PCLS + £82,600 income stream value).

The difference between Amount 1 and Amount 2 is £240,900. Therefore, HMRC would calculate the ‘transfer of value’ for IHT purposes as £240,900.

It is worth mentioning that as we are talking about a loss to the member’s estate due to a pension transfer, the IHT spousal exemption available for property that would then comprise a spouse’s estate would not be available.

Reasons for transfer

There are still reasons a client would be well-advised to make a transfer whilst in ill health as part of their wider financial planning arrangements.

Perhaps the client is single, has no dependants and the scheme rules are such that only a lump sum would be payable to any beneficiaries, or the estate. The ability for almost any individual (provided they are nominated) to designate death benefits to provide a pension (free of tax where the client died under age 75) is clearly a huge draw for people to transfer from defined benefit arrangements to arrangements such as SIPPs.

It is clear that there are risks involved with making transfers when a client is knowingly in ill-health, but they do not necessarily mean these transfers should never proceed. As always, care should be taken to ensure we are not letting the (IHT) tax tail wag the planning and investment dog.

Senior Technical Consultant

Charlene is a Chartered Financial Planner with over 10 years' experience in financial services. She joined AJ Bell in 2014 after relocating to Manchester from Bristol, where she held financial planner and paraplanner roles at leading firms. In addition to analysing and commenting on technical and regulatory issues, Charlene is also responsible for designing and providing technical training for AJ Bell staff.