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Making the right choice and knowing the risks are important when considering options for a pension.

For registered pension schemes, the inheritance tax treatment will depend upon the choices made by the individual concerned.

The general rule is that if the individual who dies is under 75 years old when they die and no benefits have been taken out of the pension scheme, then the pension scheme will not form part of the estate of the deceased for inheritance tax purposes.

Funds in personal pension schemes can then normally be paid to the beneficiaries (if under 75 years old) as a lump sum, free of tax.

Defined benefit pension schemes will usually enable payments of a lump sum to be paid to beneficiaries, free of tax. The schemes rules will usually specify how these sums should be calculated.

However, under the National Employment Savings Trust (NEST) scheme, if someone dies before using the funds to purchase an annuity, any pension funds saved in the NEST scheme will form part of their estate for Inheritance Tax purposes.

If the individual dies when they are under 75 years old and had taken a tax-free cash lump sum or income from the pension scheme, including purchasing an annuity or taking advantage of income drawdown, then any funds left in the scheme would normally be paid to the beneficiaries after a 55% tax charge has been deducted.

On the death of the holder of the pension fund the tax treatment will vary depending on the use of the pension fund by the beneficiary as follows:

  • if the remaining fund is taken as a lump sum it will be subject to a 55% tax charge
  • if the dependant is over 55 they can draw pension income which will be treated a taxable income for that beneficiary
  • if the dependant is over 55 and uses the pension fund to purchase an annuity the income from that annuity will be treated as taxable income for that beneficiary
  • funds in pension scheme could be paid to a charity. If the person who died had no dependants then the payment to charity would be free of tax. If, however, there were dependants the charitable payments would be subject to a 55% tax charge.

Death benefit nominations

If a binding nomination is in place which forces the trustees to make the payment to a nominated person, then these funds will form part of the estate of the deceased member. However, if the deceased member had supplied an ‘expression of wish’ to the trustees which is not binding on them then the resulting funds would not form part of the estate of the deceased and would therefore not be subject to inheritance tax.

Advantageous death benefit of a pre-crystallised pension fund is not clear cut if the individual is in ill-health. Problems can occur as follows:

(a)  Pension scheme member in ill-health and knows they are in ill-health, having reached Normal Retirement Date (NRD) for the scheme but has decided not to crystallise their pension fund and subsequently dies. HMRC may consider this to be a deliberate deferment in an attempt to minimise the taxable estate and avoid or reduce inheritance tax.

(b)  Pension scheme member in ill-health and knows they are in ill-health who switches their pension fund from one provider to another. HMRC view this as the ending of one trust and the beginning of another. If the member then dies within two years of setting up the new scheme HMRC can apply Inheritance Tax.

(c)  Pension scheme member in ill-health and knows they are in ill-health who makes a pension contribution (or contributions) within two years of death.

(d)  Pension scheme member in ill-health and knows they are in ill-health who is in receipt of unsecured pension, elects to reduce the income they were receiving from that pension fund in order to preserve the pension fund.

In each of the above cases HMRC can apply Inheritance Tax to the pension scheme funds. In each case the individual dies within two years of the action (or inaction) and they were in ill health and they knew about the ill health. The situation would be different if the individual dies suddenly and unexpectedly.

Making pension contributions to relatives’ pension schemes

Some payments made during an individual’s lifetime are exempt from inheritance tax such as:

  • payments up to a total of £3,000 per tax year
  • gifts in consideration of marriage (up to £5,000 by a parent, £2,500 by a grandparent or more remote ancestor or £1,000 in any other case)
  • normal expenditure out of income.

Rather than making payments to relatives directly it can be decided to make the payments into that relative’s pension scheme instead. In which case for income tax purposes the contributions are treated as though the relative made the contributions themselves and for IHT purposes the payments may be exempt (see above) or potentially exempt (a potentially exempt transfer made seven years or more before the death of the transferor is an exempt transfer and any other potentially exempt transfer is a chargeable transfer).

HMRC form IHT409 should be submitted to HMRC if the deceased received, or had made provision for, a pension or benefit from an employer or under a personal pension policy other than the state pension.

Further developments

HM Treasury is consulting about various pension changes which may come into effect from 6 April 2015. One item under consideration is to remove the age limit of 75 years of age, which may have an effect on the above guidance.

You can read a longer article on Pensions and inheritance tax on ACCA’s technical advisory webpages.

Article contributed by ACCA