Did you know that individuals who become unable to work due to ill-health may be able to draw their pension benefits early? Furthermore, those in significantly poor health may be able to convert their entire pension pot for a tax-free lump sum.
Taking pension benefits early due to ill-health
Pension legislation allows benefits to be paid before the normal minimum pension age of 55 due to ill-health in the following circumstances:
• a registered medical practitioner (RMP) confirms that the member is incapable of continuing their current occupation as a result of ill-health, which has been caused by injury, sickness, disease or disability
• and as a result, the member has ceased carrying on that occupation.
How can pension benefits be taken?
The scheme administrator will be able to confirm what benefits will be payable in the event of a member suffering ill health.
• A defined benefit (DB) scheme may pay an ill-health pension at the normal level or it might pay a reduced pension. An enhanced pension may also be payable depending on the severity of the member’s ill-health.
• Members of defined contribution (DC) schemes will potentially be able to access the full range of options available under pension freedoms – subject to the options provided in the scheme rules.
What happens if a member recovers from ill-health?
If a member recovers after an ill-health scheme pension has commenced, the scheme rules may state that payment of the pension ceases, or reduces where recovery has been partial.
Where an ill-health pension has ceased or reduced, the pension could recommence or increase back to its former level, or to an intermediate amount – this could be when normal minimum pension age is attained, or earlier, where the condition for an ill-health pension is met.
Serious ill-health lump sum
If a member’s state of health position satisfies the definition of serious ill-health, then their pension fund could be commuted as a potentially tax-free lump sum, at any age.
To be eligible, the following conditions must be met:
• the scheme administrator has received evidence from an RMP that the member has a life expectancy of less than one year;
• benefits are payable from uncrystallised funds;
• the benefits payable use up all remaining uncrystallised rights under the arrangement; and
• the member has available lifetime allowance.
How is a serious ill-health lump sum treated for tax purposes?
A serious ill-health lump sum that is paid before a member reaches age 75 will be paid tax-free on the proviso that the individual has an available lifetime allowance.
Benefits taken are tested against the lifetime allowance as a benefit crystallisation event with any payment made above the available lifetime allowance incurring a charge of 55%, which the scheme administrator must account for.
Where benefits are being paid from a DB arrangement, the scheme administrator will calculate a capital value equivalent to the benefits being commuted for the lump sum.
If a serious ill-health lump sum is paid after a member reaches age 75, the payment is taxed as pension income at the member’s marginal rate of income tax. Although benefits aren’t tested against the lifetime allowance, the member must have lifetime allowance available which for these purposes ignores the lifetime allowance test which would have applied to unused DB or DC funds when the member attained age 75. However, any benefits already taken post age 75 that would have been tested against the lifetime allowance had they been taken before that age are treated as if they had been tested against the lifetime allowance.
A serious ill-health lump sum will be treated as part of the member’s taxable estate for inheritance tax purposes. However, any potential inheritance tax liability may be outweighed by the benefit of obtaining the funds during the member’s lifetime.
Transferring pension death benefits whilst in poor health
The advent of pension freedoms had led to increased interest in transferring from a DB scheme to a DC scheme with a new provider. This may provide the potential for improved benefits, greater flexibility and increased tax-efficiency. However, there’s a potential trap for those considering this that are in poor health. If an individual transfers their pension death benefits from one scheme to another, and dies within two years, HMRC may seek to treat this as a transfer of value for inheritance tax purposes – if it regards the individual was in poor health at the time of the transfer.
If you would like to learn more about the impact of ill-health on your pension benefits, and the options available to you, please contact one of Springfield Financial Services Ltd’s Chartered Financial Planners and Pension Specialists on 01772 729742.