I have been running various adviser events around the country over the last few weeks and a regular question has arisen connected to the rising numbers of final salary transfers. What is the inheritance tax position, especially if the transfer is driven by the desire for better death benefits and the customer is in relatively poor health?
The number of final salary transfers being considered has increased rapidly since the pension freedoms. Better death benefits are a key driver in many cases.
In occasional circumstances, IHT can be factor when a transfer takes place. It can be argued this is an unfair rule: in most cases, the money is moving from one scheme where death benefits would be free of IHT to another. However, by transferring, the individual has the power to determine the payment of death benefits. HM Revenue & Customs believes this right has value because the member could direct payment to their own estate – however unlikely it is.
If the individual dies within two years of making a transfer, the executors are required to report this to HMRC. At that point, the customer’s health (and their knowledge of it) when they made the transfer becomes relevant.
If the person was in normal health, HMRC deems there to be no loss to the estate. However, if the person knew they were seriously ill when the transfer took place (expecting to live for less than two years) then an IHT charge can arise.
At this point, a valuation will determine the loss to the estate. The difficulty here is that HMRC has significant discretion and the calculations are not specified anywhere. However, it is important to note it is not simply the transfer value that is taken into account. Instead, HMRC will value the death benefits that could have been paid to the estate from the new contract, then deduct the value of the retirement benefits the member could have taken before death.
Historically, this has been tax-free cash plus the value of an annuity with a 10-year guarantee that could have been bought (taking into account tax, inflation and the non-assignability of an annuity). With pension freedoms, that may no longer be a suitable measure, so it is feasible HMRC may simply add the tax-free cash to the remaining fund minus any income tax due.
It is worth bearing in mind that transferring could still be the best outcome, even if there is an IHT charge. For example, if a final salary scheme provides poor death benefits it may be advantageous to transfer to another scheme that pays a return of fund, as the family would receive a higher value, even after the IHT charge.
There are many reasons why people consider transferring from a final salary scheme. If death benefits are a key driver due to the ill health of the member, being aware of the IHT position is crucial, although a transfer may still be the best outcome.
Andrew Tully is pensions technical director at Retirement Advantage