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Case study: Don’t let pension transfers snatch IHT benefits

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David has been to see a potential new client about pensions. Paul was a friend of an existing client but took the view pensions were an easy subject. He was somewhat reluctantly seeing David, as it had been suggested he could do with some specific advice, particularly around death benefits and inheritance tax.

Paul was in his early sixties and had built up several pension pots over his career. He was now starting to think about retirement and the investment strategy that would take him there.

In a nutshell, he did not want to buy an annuity (at least for a few years), preferring to use income drawdown instead. He had also read that any remaining fund on death should be able to be passed onto his heirs free of tax. Indeed, he held the common view pensions were now “IHT-free”. 

His current pensions consisted of an old defined benefit scheme giving him benefits of £10,000 per annum with a cash equivalent transfer value of some £210,000, and a couple of personal pensions, one worth about £400,000 and another about £200,000.

The two personal pensions were invested in old policies with a limited selection of funds, so the idea of transferring for a wider investment range (i.e. into a Sipp) would be part of the strategy.

In their first discussion, Paul had referred to health problems several times yet stuck by his principle he had heard pensions were now IHT-free.

This was one of David’s bugbears. He understood where it came from – as the abolition of the “death tax” has revived interest in the tax-free passing on of pension benefits – but they are certainly not IHT-free in all circumstances.

While the potential charge to IHT under section 3(3) IHT Act 1984 for omitting to exercise a right to take benefits had been removed from April 2011 (Fryer and Ors v HMRC) he knew there were still real issues. A quick discussion with his favourite pensions technician was in order.

His starting point had been that the three plans were all in schemes written under trusts that offered an IHT-efficient disposal of death benefits and the receiving schemes would do also. A transfer between the two would, in theory, be straightforward. But David knew it might not be so easy.

He had been informed that, although this was the logical approach, it was not how HMRC saw a transfer. It took the view that when the transfer is made the individual has, in effect, surrendered their rights under their old pension plan in return for rights under the new one. While the funds do not actually go back to the member’s estate during the transfer, the right to determine the terms of the payment of death benefits in the new scheme becomes available to the individual. This right has a value because the member could potentially direct that death benefits under the new scheme are paid to their estate (even though they probably would not) and, therefore, there could be a loss to the estate if the provisions under the new scheme mean it would not benefit.

So, when the member exercised that “right” by choosing to give away the new death benefits, there was a loss to their estate for IHT purposes and, in the event of death within two years of transferring a pension plan, there could still be an IHT charge because the individual will be treated as making a transfer of value under section 3(1) of the IHT Act 1984.

This would need to be reported to HMRC so it could ascertain whether an IHT charge could result if the individual knew they were in serious ill health when they made the transfer. If the member did die within two years but did not know they were suffering from a life-threatening illness when they made the transfer there is an argument to say there was no intention to confer a gratuitous benefit and there should not be an IHT charge.

To make sure David could understand and advise Paul accordingly he would need to discuss the nature of the health problems and whether they were likely to be life threatening.

David has come across a number of clients looking to move pension plans, either to consolidate or move them from providers not offering the new freedoms. As these exercises take place at older ages, it is statistically more likely clients will be transferring in ill health and, as such, still have potential IHT issues.

David has developed his own mantra to counter the IHT-free message:

“Anybody who has a pension plan with substantial death benefits and who knows they are in serious ill health should exercise care before making any changes for pension freedoms or even just commercial and investment issues. By transferring they might lose their IHT efficiency.”

Mike Morrison is head of platform marketing at AJ Bell 

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