Accessing pensions early due to ill-health

If a client has to stop work permanently due to ill-health, they’re likely to have a raft of issues to sort out, whether it’s childcare support, housing decisions or ongoing medical care. Underpinning all this is the financial aspect – where once they had a regular salary or self-employed income coming in, that will now have stopped.

They might have critical illness or income protection insurance that will pay out specifically in this type of situation. They could also have general savings in the form of investment accounts or ISAs, which can usually be accessed at any time. A pension, however, is often a client’s largest source of funds, but these cannot normally be accessed until they’ve turned 55. Fortunately, the tax rules do allow early access in a couple of situations, which we’ll look at in this article.

Ill-health condition

The first is the ill-health condition, for which there are three requirements.

The individual:

• must be incapable of their current occupation due to injury, sickness, disease or disability
• must continue to be incapable of their current occupation
• must have ceased to perform that occupation

The first two requirements are a question of opinion, that being of a registered medical practitioner, and the scheme administrator will require written evidence. The third requirement is a question of fact.

In terms of occupation, this is the client’s current occupation, and not any occupation, so you could conceivably have two clients with the same medical condition, but only one meets the requirements as their occupation was a manual occupation. If the client has already stopped work several years earlier, it’s the occupation that is most relevant to them. Expect scheme administrators to ask about this.

If these requirements are met, the client can access their pension in the normal way. So, for example, they could take a tax-free lump sum and put the remainder into drawdown or purchase a lifetime annuity. These will be tested against the lifetime allowance.

They could also opt to do a partial crystallisation if they wanted to, and ideally they might want to leave as much in their pension as possible given the funds could be distributed free from income tax (before age 75) and free from inheritance tax (IHT).

It’s important to note that these are the minimum requirements as per legislation, and some schemes may have stricter rules. Each scheme administrator will have its own process and paperwork for this as well, so it’s worth contacting them as soon as a client has indicated they might need to go down this route.

Serious ill-health

The other early access scenario is serious ill-health, and there are different requirements for this.

The individual must:

• have less than twelve months less to live
• have ‘some’ LTA available

Again, the first point has to be supported by evidence from a medical practitioner.

If the requirements are satisfied, the client can withdraw their pension as a single lump sum which is entirely tax-free. The lump sum would be tested against the lifetime allowance. If the lump sum exceeds the lifetime allowance, the excess will be taxed at the client’s marginal rate of income tax.

However, while the tax treatment is more favourable than under ill-health, there is less flexibility given the rules require the client to withdraw the whole pension in one go.

Ill-health or serious ill-health?

If a client is eligible for a serious ill-health lump sum, they’ll almost certainly be eligible under the ill-health condition as well, so they could have a decision on which route to go down.

From a planning perspective, taking pension benefits under ill-health allows more flexibility in terms of partial crystallisations. Importantly, it still leaves the door open for a serious ill-health lump further down the line, even if it relates to the same underlying illness.

It’s worth considering the IHT aspect as well, as any funds withdrawn could later be subject to IHT on death, which they wouldn’t be if left in the pension. This again might lead a client to favour ill-health if they don’t require all of the funds for their expenses.

Where a serious ill-health lump sum might still be appealing, however, is for smaller fund values and where IHT isn’t likely to be an issue. The client would receive the whole amount tax-free and would then have full control over how to use or distribute the funds, whether it’s holidays, gifts or charitable donations, rather than having them distributed by trustees or scheme administrators who are likely to act within a much narrower remit.