Ill-health and pensions: understanding early access options

The normal minimum pension age (NMPA), when most individuals can access their pension, is currently set at age 55. This is due to increase from April 2028 to age 57 and from then on, the minimum pension age is planned to further rise in line with the state pension age so that it is always ten years below. Accessing a pension before NMPA will be classed as an unauthorised payment and have significant tax penalties unless the client meets certain criteria.

This article examines the options for accessing pension benefits early for individuals who are experiencing ill-health or have a limited life expectancy. It highlights the circumstances under which early access is permitted, the processes involved, and the potential tax implications.

Early payment of benefits on health grounds

Clients may receive authorised payments from their pensions before reaching the normal minimum pension age if they meet the criteria for ill-health. This is commonly known as ill-health retirement. The ill-health condition is satisfied if the member:

While the above criteria form the standard basis for ill-health retirement, the specific rules of individual pension schemes can be stricter. For example, some schemes may define incapability as being unable to perform any occupation rather than just the member’s current occupation.

Evidence required for ill-health retirement

When applying for ill-health retirement specific evidence must be provided to demonstrate that the required conditions have been met.

To confirm eligibility, the evidence must clearly show that the individual meets the ill-health conditions, including their inability to perform their current (or, in some cases, any) occupation due to medical reasons.

The evidence must be supplied by a suitably qualified medical practitioner. This ensures that the assessment is reliable and aligns with the standards required by the pension provider. In this context a suitably qualified medical practitioner refers to an individual who is fully registered under the provisions of the Medical Act 1983. The practitioner must be registered with the General Medical Council (GMC), the regulatory body responsible for overseeing medical professionals in the UK and the individual must hold an active licence to practise under the act.

There is no fixed format for how the evidence must be presented, allowing pension providers to accept either a detailed letter from a qualified medical professional outlining the nature of the individual’s health condition and its impact on their ability to work, or a formal declaration form completed by the medical practitioner, specifically addressing the ill-health criteria set out by the pension scheme.

Understanding the requirements of specific pension schemes is important, as definitions and evidential standards may vary.

When the medical evidence has been reviewed and accepted, and the member has officially ceased working in the relevant occupation, they will be eligible to begin receiving benefits under the scheme. At this point, the member can choose from the same range of options that would have been available to them had they accessed their benefits at the scheme's normal retirement age.

Any benefits taken will be subject to taxation in the same manner as if they had been accessed at the normal retirement age. Up to 25% of the uncrystallised funds, up to the member's available lump sum allowance (LSA), can be taken as a tax-free pension commencement lump sum (PCLS). The remaining funds can then be designated to provide an income, which will be subject to income tax at the member's applicable rate.

For money purchase schemes the options may include flexi-access drawdown, an annuity, an uncrystallised funds pension lump sum (UFPLS), or taking benefits under the small pots rules. It may also be possible to phase taking the benefits.

If the decision is made to purchase an annuity, the member may have access to more favourable rates through providers that offer "impaired life" or "enhanced" annuities. These types of annuities consider the member's health and lifestyle factors, which can result in higher payouts compared to standard annuities. Chronic illnesses or other medical issues that may reduce life expectancy can qualify the member for these enhanced rates. For clients in ill health it may be beneficial to explore these options thoroughly, as they can significantly improve the level of income provided over the course of the annuity.

For benefits paid early from defined benefit schemes the scheme rules will decide how the benefits are calculated. Under normal conditions this type of pension is reduced if it is accessed before the normal retirement age. However, many pension schemes waive this reduction if the pension is taken early due to ill health. This ensures that individuals facing health challenges are not financially penalised for accessing their benefits earlier than planned.

In such cases, the maximum amount payable is generally equivalent to the pension the individual would have received had they continued working and contributing to the scheme until their normal retirement date. It is important for members to check their specific scheme rules to understand the provisions available in cases of ill health. If the total benefit value is small, it may be possible to take them as a taxable lump sum under the small pots rules or as a trivial commutation lump sum.

If a member takes benefits early due to ill health, these benefits may stop if they recover and return to work. This is rare as the member must initially be medically assessed as unable to work on an ongoing basis. The rules do recognise that health conditions can improve, allowing for the possibility of recovery.

If a member does recover, any benefits already received remain authorised provided the eligibility criteria were met when the payments began. Recovery does not automatically mean benefits must stop, although some scheme rules may require this. The key consideration is the member’s condition at the time benefits were first granted.

Serious ill health

If a member is experiencing serious ill health, the scheme administrator may have the option to pay their pension entitlement as a lump sum payment, provided certain conditions are met. Under legislation, this payment is referred to as a serious ill-health lump sum (SIHLS).

There is no minimum age requirement for receiving a SIHLS. For a payment to qualify as a SIHLS all the following conditions must be met:

Because of this, it is not possible to partially crystallise a pension to provide a SIHLS with only some of the funds. Additionally, those who have already reached the NMPA and have previously crystallised all their pension cannot draw the fund under this condition.

A SIHLS can be completely tax-free when paid before the age of 75. The payment is a relevant benefit crystallisation event (RBCE) which means there is also a test against the member’s lump sum and death benefit allowance (LSDBA) but there is no test against the member’s lump sum allowance (LSA). Any funds paid in excess of the member’s available LSDBA would be subject to income tax at their marginal rate.

It is possible to take a SIHLS after the age of 75 but the whole amount will be subject to income tax, so there is little benefit to doing this rather than taking a drawdown payment.

Ill-health retirement and inheritance tax

Under current rules most pensions are usually free from inheritance tax (IHT) upon the member's death, as the pension does not form part of the deceased’s estate. Although it is worth noting that even with these current exemptions, there are circumstances where pensions can have IHT implications.

One factor in determining whether IHT is payable is whether the estate was entitled to or guaranteed to receive benefits due in respect of the deceased member. If death benefits are distributed through a binding nomination where a named beneficiary is specified in an instruction that the pension scheme trustees are obliged to follow, then IHT will apply as the trustees have no discretion over the distribution.

A pension could also be liable for IHT where a ‘lifetime transfer’ has occurred. Lifetime transfers are known as ‘dispositions’ and can include transfers between pension schemes and contributions made to pensions. If a lifetime transfer is made while a member is in ill-health and they pass away within two years, that prior transfer can potentially impact the calculation of any IHT due if HMRC deems there to have been any loss to the estate.

With the rules today taking a SIHLS will generally only be advisable if the client has an immediate need for the funds or if their total estate will remain within the IHT nil rate band. If the lump sum is simply withdrawn and added to their estate, it could increase their IHT liability, making it a less favourable option for those who are terminally ill.

Changes to how pensions are treated for IHT are proposed to start from 6 April 2027. Under these new rules, any unused pension funds remaining at the time of death will be included as part of the deceased's estate for IHT calculations. This means that individuals in ill-health may be able to reassess their estate planning strategies to minimise tax liabilities and protect wealth for their beneficiaries. Drawing a pension from the previously IHT exempt funds, particularly if there is scope to make exempt gifts, may be a useful option for those in ill-health. The changes will also remove the uncertainty of transferring and combining pensions while knowingly in ill-health as the tax treatment on death will be consistent.

For individuals facing health conditions, understanding the full range of options for early pension access is essential to securing long-term financial stability and making the most of their pension benefits. Early access to pension funds can provide much needed financial support during a period of reduced or lost earnings, but the decision should be approached with careful consideration of both immediate needs and long-term implications.