What advisers need to know to help clients access much-needed funds from their pension pots
Pension funds give the impression of being under lock and key until age 55. But that is not always the case. People can unlock them earlier than that but only under specific circumstances – for example, either through ill-health early retirement or severe ill health.
It is worthwhile understanding how these rules can help clients access their pension pots at life-changing times when they may desperately need the funds.
Let’s look at early retirement first. This is where the client is unable to physically or mentally carry on working in their current job due to
ill health, and wants to access benefits early.
Note here that some individual scheme conditions may be stricter. Certain scheme rules are written so members must be incapable of carrying out any occupation, not just their own. So, it is always worth checking.
If a client wants to apply for early retirement, they must provide evidence from a registered medical practitioner that they are incapable of continuing their current employment. They also need confirmation they have stopped their current employment – for example, a P45.
The client can crystallise their benefits from the pension plan. They get the usual choice of benefits (for instance, taking tax-free cash, buying an annuity or entering drawdown) but at an earlier age. The usual flexibility applies to income drawdown withdrawals, so they can be reduced, increased or stopped at any time.
A defined benefit scheme’s rules will outline the level of pension to be paid out. Some schemes reduce the pension as it is paid from an earlier age, but others may increase the payment if there is a shorter life expectancy.
Scheme pensions paid on ill-health grounds may be reduced or stopped at any time. This allows an employer to pay a pension which fits in with the member’s capacity to carry out their occupation; for example, if the member subsequently recovers or partially recovers from ill health.
However, if the scheme pension does start again or goes back up to a previously higher rate, there may be a further test against the lifetime allowance for the period of re-employment.
There is no special tax treatment for early retirement through ill health. Pension income payments are taxed as earned income as normal. And any crystallisations will be tested against the lifetime allowance as usual.
This is a useful way for someone to get hold of an income to support them in ill health or some much-needed emergency funds for things such as house modifications or the costs in travelling for treatment.
Severe ill health
If the client is in severe ill health – where they are not expected to survive for more than another 12 months – slightly different rules apply to reflect the more extreme circumstances.
Again, clients will need confirmation from a medical practitioner, this time that they have less than 12 months to live. As long as they have not used up all their lifetime allowance, their uncrystallised pension funds can be paid out as a serious ill-health lump sum. But it is an all or nothing rule – they cannot choose to take part of the fund and leave the rest uncrystallised.
If the client has already designated part of their pension funds into drawdown, any remaining uncrystallised funds must be taken as a lump sum, rather than move it into drawdown to join the rest of the pension funds.
If the client is 75 or over, their unused pension funds would have already been tested against the lifetime allowance (at age 75). However, when working out if the client has used up all their lifetime allowance, the results of this earlier test should be ignored.
Any serious ill-health lump sum paid out will be tested against the lifetime allowance. The rule is the pension scheme member must have some available lifetime allowance left – but they do not have to have enough to absorb the whole of the payment. So, if by paying the lump sum, there arises an excess over the lifetime allowance, this is subject to a lifetime allowance charge of 55 per cent as usual.
Finally, taxation. If the member is under 75, the serious ill-health lump sum can be paid out tax free. If over 75, it is subject to tax at the client’s marginal rate.
Obviously, a tax-free lump sum is going to be of great help to clients (aged under 75) who unfortunately find themselves in this situation, but it does move the money into the estate. If the client does not need the funds, they may want to instead leave them in the pension and pass them to the family on death, free of any inheritance tax.
Rachel Vahey is product technical manager at Nucleus