A look at the theory and calculations around this tricky area of financial planning
Inheritance tax and pension transfers is an area we have always had a lot of questions from advisers on, so it is worth taking a look at the theory and calculations around it. In HM Revenue & Customs’ eyes, when a client transfers pension rights, they effectively surrender their rights under one scheme in return for those under another. When looking at a potential IHT claim, it reviews the difference between the open market value of the:
- Death benefits which could have been directed to the estate;
- 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 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 are not expected to live much longer. The transfer of value is substantial and subject to an IHT claim by HMRC.
Freedom and choice 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.
When calculating the value of the lifetime rights, it is now more appropriate to consider uncrystallised funds pension lump sum, which actually reduces the impact of the transfer for IHT, rather than HMRC’s previous assumption of pension commencement lump sum, plus a 10-year annuity.
John was terminally ill and had 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 died 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 – 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 per cent growth and a discount rate of 7.5 per cent. The latter could be measured as the net value of a £500,000 UFPLS.
So, with a tax-free amount of £125,000 plus £210,000 after tax (assuming no other income), a net lump sum of £335,000. The difference equals deemed loss to the estate: £480,000 – £335,000 = £145,000. Is an exemption available?
It is often assumed that any spouse or civil partner who ultimately receives 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) does 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 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 says that if drawdown income continued at least at the same level after a transfer as was payable before, then it is unlikely to make a claim.
Although the IHT409 form collects information on transfers within two years of death, cases transferred in ill health outside of this transfer window could, in theory, be challenged.
Thanks to Section 200 of IHT 1984, 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 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 with 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.
Charlene Young is senior technical consultant at AJ Bell