IHT and pension transfers - an update

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I first wrote on this topic for MM some years ago, but it is worth revisiting the theory and the calculation given that we still get asked questions on this area today.

What is the issue?

In HMRC’s eyes, when a client transfers pension rights, they effectively surrender their rights under one scheme in return for rights under another.

When looking at a potential IHT claim, they look at the difference between the open market value of the:

  1. death benefits that could have been directed to the estate; and
  2. lifetime rights comprised in the receiving scheme.

If we consider money purchase pensions, the theory is that the death benefits at the point of a transfer have less value for clients in good health because there is a reasonable chance that they will use their pot to take all or some benefits in their lifetime. The difference (known as a transfer of value) is minimal and there is no potential IHT claim.

Where a client was knowingly in ill health at transfer, there is less chance of the pot available for death benefits being depleted simply because they aren’t expected to live much longer. The transfer of value is substantial and subject to an IHT claim by HMRC.

Freedom and choice obviously reformed how clients can access their lifetime pension benefits as well as the death benefit options available to their beneficiaries. This in turn has impacted how the open market value of the rights can be calculated since my previous article.

When calculating the value of the lifetime rights, it is now more appropriate to consider UFPLS, which actually reduces the impact of the transfer for IHT, rather than HMRC’s previous assumption of PCLS plus a 10 year annuity.

Case study – John

John is terminally ill and has been given less than a year to live.

He transferred a retirement annuity contract worth £500,000 on 1 May 2018 to a SIPP but unfortunately dies within 12 months of the transfer.

His executors duly report the transfer on the IHT409 form but what might the IHT liability be?

Loss to estate on transfer = open market value of death benefit minus open market value of the lifetime benefits.

In John’s case, the value of the death benefit will be close to the transfer value as his prognosis was very poor at transfer date. Let’s assume £480,000 after 3.5% growth and a discount rate of 7.5%.

The latter could be measured as the net value of a £500,000 UFPLS. So a tax-free amount of £125,000 plus £210,000 after tax (assuming no other income). So a net lump sum of £335,000.

Difference = deemed loss to estate: £480,000 - £335,000 = £145,000.

Is an exemption available?

It is often assumed that if any spouse or civil partner who ultimately received any death benefits from such a transfer would benefit from an exemption to IHT.

Unfortunately this is not the case. The property transferred (the pension rights) do not comprise the spouse’s estate and at the time of transfer, there was a loss to John’s estate rather than a transfer to his spouse.

In John’s case the loss is below the nil rate band (NRB), so IHT may not actually be payable in relation to the transfer.

However, the amount of John’s NRB used will not be available for the rest of his estate which could alter the estate’s position – and any NRB used would also not be available for any spouse or civil partner on the second death.

What about drawdown to drawdown transfers?

HMRC say that if drawdown income continued at least at the same level after a transfer as was payable before, then they are unlikely to make a claim.

In practice

Although the IHT409 form collects information on transfers within 2 years of death, cases transferred in ill health outside of this transfer window could in theory be challenged although it isn’t clear if this happens regularly in practice.

Thanks to section 200 of IHT1984, beneficiaries may also find that providers withhold some funds until they receive appropriate confirmation that any IHT matters are settled with HMRC. This is because the legislation actually allows HMRC to call on the trustees or scheme administrators to settle an unpaid IHT bill in relation to a lifetime transfer.

Even where a client is in poor health, a transfer may still be the right thing despite the IHT threat. However, we can agree that the calculation is at best complicated, and can still create significant uncertainty when considering the merits of a transfer with clients.

Consistency can be an issue too – advisers have told me about ill health transfers where they helped executors to fully disclose details upon the client’s death, but to their surprise no claim or action was taken by HMRC. Contrast this to the Staveley case, on which proceedings started in 2012 and concluded last year at what one must assume significant cost on both sides, and distress for the family concerned.

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.