Are Pension Funds Always Free of Inheritance Tax?
It is a generally accepted benefit of pensions that a pension fund that has not been crystallised (where a Tax Free Lump Sum has been received) can be passed on to a beneficiary without any Inheritance tax being applicable. This is, in most cases, true. However, there an increasing number of occurences that demonstrate the situation is not so black and white and that HMRC are becoming increasingly active in cases in which they believe IHT should be applied.
The first situation is where a pension scheme member is in ill-health, has reached the Normal Retirement Date (NRD) on the scheme but has chosen not to crystallise their pension fund, and has then subsequently died. A recent case has suggested that HMRC may view this as a deliberate deferment in an attempt to minimise the taxable estate and maximise benefits paid to beneficiaries (in 1984 IHT Act parlance “a failure to act”). Had they opted for the alternatives there would be no fund to pass on (annuity purchase) or the lump sum passed on would have a 35% tax charge (Unsecured Pension, also known as ‘Income Drawdown’).
A second situation involves the switching of a pension from one provider to another. Pension funds are written under a trust, typically a ‘master trust’ run by the pension scheme provider. The provider, as trustee, has the discretion over who receives the post death pension fund and therefore in normal circumstances it does not constitute part of an individual’s estate. Where a member is in ill health, however, and the pension fund has been switched from one pension provider to another HMRC deem this to be the ending of one trust and the beginning of another. If the member then dies within 2 years of setting up the new scheme HMRC can apply Inheritance Tax even though the pension fund was previously within a trust arrangement and regardless of appropriateness of the pension switching advice!
This ruling could also apply if a pension contribution was made within 2 years of death by an individual in ill-health or if that person, whilst in Unsecured Pension, elected to reduce the income they were receiving in order to preserve the pension fund.
The conclusion of this is that the advantageous death benefit of a pre-crystallised pension fund is not so clear cut when it involves individuals in ill-health who die within 2 years of taking the action described above and at that time they knew they were in ill health. It should also be noted that these situations are in particular reference to a person in ill health and not where an individual dies suddenly and unexpectedly