Defined benefit (DB) transfers have surged since the introduction of pension freedoms.
It is reckoned that more than 100,000 people have left their final salary pension in the past 12 months, and rising.
According to Retirement Planner, there are a number of reasons for this.
The first is flexibility – instead of taking a set pension on a set date, you have much more choice how and when you take your pension.
Many DB pension schemes offer a pretty poor deal if you want to convert part of your DB pension into a tax-free lump sum. Although the tax-free cash is in theory 25 per cent of the value of the pension, you often lose more than 25 per cent of your annual pension if you go for tax-free cash. In defined contribution (DC) schemes, you get exactly 25 per cent.
Then there is inheritance – generous tax rules mean that if you leave behind money in a DC pension pot it can be passed on with a favourable tax treatment. In a DB pension, while there may be a regular pension for a widow or widower, there is unlikely to be a lump sum inheritance to children.
Every year some employers go bankrupt. If the DB pension scheme goes into the Pension Protection Fund, you could lose 10 per cent if you are under pension age, and may get lower annual increases. But if you have transferred out, you are not affected.
Now however a court ruling has muddied the waters around inheritance – pension savers in ill-health are at greater risk of their loved ones being hit with a 40 per cent IHT bill.
Current rules mean that if someone is in ill-health and they decide to transfer their defined contribution pension but subsequently die within two years, the sum is subject to inheritance tax. But most transfers are exempt as long as the transfer was not meant to confer a ‘gratuitous benefit’ on the member.
However that is now up in the air following a landmark ruling in the Staveley Case which centred on the decision by a divorcee to transfer her pension and bequeath the money to her children, rather than leave it in an existing scheme benefiting her ex-husband.
This move was taken when she was terminally ill and she died a month later.
HMRC argued that as she had not drawn on the pension benefit, the transfer conferred a ‘gratuitous benefit’ to her sons. Further, it said she deliberately designed it to reduce the value of her estate for IHT purposes. As such, HMRC applied an IHT charge. This decision was challenged by her sons and the Upper Tribunal of the Tax and Chancery Chamber rejected HMRC’s arguments. But the Court of Appeal recently overturned this ruling in favour of HMRC.
Speaking to YourMoney.com, Tom Selby, senior analyst at AJ Bell, was scathing.
“What we are left with is a complex, nonsensical web of rules which risk layering on extra worry for beneficiaries at a time where they are likely to be suffering from serious emotional distress,” he said.
He urged the Government to exempt pensions from IHT altogether.
Ian Browne, pension expert at Quilter, took a similar view, saying terminally ill people would be penalised for good financial planning. “This is a legacy of an outdated inheritance tax system, which remains off kilter with pension freedoms. The Chancellor has the power to set this glaring discrepancy straight.”
In the meantime be extra careful you do not succumb to such pitfalls. Don’t leave it until you are in ill-health if you are mulling taking action on transfers.