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Case Study: The merits of ill-health early retirement

The Issue

– Mrs Jones, aged 49, has been seriously unwell for a couple of years now, and has not worked for the last three years. She has a preserved money purchase pension pot of £600,000, and wants to consider her options in terms of potentially accessing these funds and the possible taxation implications.


Accessing pension benefits before the minimum retirement age of age 55 is possible on grounds of ill-health subject to certain transitional reliefs.

The drawing of these benefits is considered a benefit crystallisation event and a lifetime allowance test will apply, but there is no adjustment made to the lifetime allowance to take into account this early retirement.

An “Ill-health condition” as defined by The Finance Act 2004 is when the scheme administrator receives evidence from a registered medical practitioner that Mrs Jones is incapable of carrying on with her occupation (both presently and the future) because of physical or mental impairment, and she has ceased to carry on with her occupation.

Although this implies a permanent condition, the Act allows a scheme to cease or reduce payments of an ill health pension if her health eventually improves. However, there is nothing to stop a scheme adopting a harsher definition in its own rules, such as, “any occupation” as opposed to “own occupation”.

If she satisfies the ill health early retirement rule, then she would normally be eligible for an impaired life annuity, with the possibility of taking the pension commencement lump sum.

If she requires a dependent’s annuity, then the benefit of choosing an impaired life annuity is reduced, as the higher mortality of the dependent will be reflected in the higher price of a joint annuity.

Alternatively, she could purchase a single life impaired annuity up to the level of the minimum income requirement of £20k, and obtain flexible drawdown on the residual fund.

If achieving maximum income is not the prime objective from the pension, then she could consider drawdown or phased drawdown in order to maximise death benefits, as these would be potentially exempt from inheritance tax.

HMRC allows a pension fund to be paid as a one-off lump sum on the grounds of serious ill health if she has a life expectancy of less than 12 months.

She must have some lifetime allowance remaining and the pension pot in question must be commuted in full.

If she has any other pension benefits, then they do not need to be commuted at the same time. The scheme administrator must obtain a confirmation from a registered medical practitioner that her life expectancy is less than one year before they can make any payments.

As the value of her fund is less than the lifetime allowance, the payment will be tax-free (taxed at 55 per cent if aged 75 or older) Any excess over the lifetime allowance will be taxed as an unauthorised payment, unless protection has been registered. Also this commutation is exempt from any annual allowance charge.

If she is claiming any mean tested state benefits during her time of ill-health, then any access of her pension fund whether lump sum or regular income will need to be taken into account, and its financial impact carefully analysed.

This is a potential minefield, and as you can see from the paragraphs above, the decision as to whether to access pension funds early in whatever form should not be taken lightly.

Aj Somal is a chartered financial planner at Aurora Financial Planning


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