How inheritance tax might apply to a pension transfer (deceased estate taxed in England)

This is a complex area but one of the main areas which has caused problems is where the individual is terminally ill and transfers from one scheme to another and dies within 2 years. Most commonly this is from a Defined Benefit (DB) scheme to a Defined Contribution (DC) scheme as the DC scheme will probably offer more flexibility. HM Revenue & Customs (HMRC) considers this to be a transfer of value due to the fact the individual could direct the transfer to an arrangement where the estate would be entitled to the death benefit.

If an individual is transferring when in poor health then they have to be aware of the potential IHT implications. However, even if 40% IHT is applied to the transfer value (and it may not be as high as this due to the way it is calculated) then 60% of something is better than nothing which is likely to be what a non-dependent adult beneficiary would receive from a DB scheme.

In this case study we look at Mark.

• Mark lives in England, is divorced and terminally ill.
• Earnings in the tax year £150,000.
• He has 2 adult non-dependent children.
• He transfers his DB pension to a DC scheme and dies 2 months later.
• The transfer of value is £1 million.

As Mark dies within 2 years of the transfer taking place, IHT may be payable if the value of the estate exceeds the nil-rate band.

In broad terms for IHT purposes it is the difference in the value of the death benefits in the previous scheme and the retirement benefits in the receiving scheme that’s used to calculate the IHT.  The actual values will be negotiated between HMRC and the personal representatives of the estate.

Before figure

This is the open market value of the death benefits which could have been directed towards the individual's estate. This is slightly confusing as it is not the rights there would have been if the individual had stayed in the DB scheme. Instead, it is the transfer value (the death benefit in the receiving scheme).

Growth is applied and a deduction is made for the period that the individual is likely to survive (you would not pay full price for something you were not going to receive until a future point) and this then gives the open market value. So, the deduction is calculated using both a growth rate and a discount rate.  In Mark’s case he died shortly after the transfer so the open market value is high.

In Mark’s case HMRC state it to be £980,000

After figure

This amount should be the amount of an uncrystallised funds pension lump sum (UFPLS) less what the tax payable would be on a full withdrawal.

• 25% of £1m taxed at 0% = £250,000
• Income tax of 45% of £750,000 (other taxable income of £150,000) = £337,500
• Value of retained rights £1m - £337,500 = £662,500

Loss to the estate: 

Before figure – After figure

= £980,000 - £662,500 = £317,500

This amount is added to the value of Mark’s estate when calculating whether IHT is payable.

Note

The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.

All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.