Inheritance Tax on Transfer to Flexible Drawdown HMRC 2 Year Rule

Inheritance Tax on Transfer to Flexible Drawdown HMRC 2 Year Rule

HMRC consider transfers of pension benefits from one scheme to another to be transfers of value and therefore taxable is you die early as there is a loss to the estate.

Rights “Before” the transfer
This is the open market value of the death benefits which could have been directed towards the member’s estate. It is not the rights which there would have been if the member had stayed in the company pension scheme, it is the transfer value i.e. the death benefit. Growth is applied to the death benefit amount and
a deduction is made for the period that the member was likely to survive and this then gives the open market value.

Transfer Value + Growth (or loss) to give Death Benefit Value at date of death less a deduction for the period the member was likely to survive e.g. if unexpected death then likely to survive 20 + years, if terminally ill then only a small deduction – what would they have got if they were drawing on it!

Rights “After” the transfer
This is the open market value of the pension rights available after the transfer, again, in the new pension scheme. This is the amount of an uncrystallised (not paid out yet) funds pension lump sum (UFPLS) less what the tax payable would be on a full withdrawal.

Value of uncrystallised pension fund lump sum less tax payable if fully encashed and tax would have been paid on it all. 

Before Value Calculation: E.g. Transfer Value £800k – death 6 months less an amount that could have been taken whilst alive and in the pension original pension scheme – e.g. £20k

Before Value = £780,000

After Value Calculation  = £200k Tax free cash lump (25%) and taxable balance £600k (total £800k).  Is then assumed taxed at income tax rates – if assume you are on £20k pa pension/income already i.e. taxable income that year would have been £620k, income tax payable (if had cashed in whole £600k) = £261k.

Value of Retained Rights = £800k - £261k = £539K (this is the After Value).

Therefore the Loss to Estate = BEFORE Value less AFTER Value

BEFORE value (£780k) less AFTER value (£539k) = £241k loss to the estate.  This is the loss to the deceased’s estate.

As it is a transfer of value to a pension scheme, there is no spousal exemption available.

The Loss to Estate will use up the first £241k of your inheritance tax nil rate band.  So if transferring all values to your spouse then they would pay no tax anyway but surviving spouse would only have – ‘unused’ deceased’s IHT allowance of £325k less £241k = £84k on unused transfer to spouse IHT allowance.

If there is NO SPOUSE, then the deceased’s IHT allowance is reduced to just £84k and rest of taxable estate is subject to lower IHT allowance meaning more inheritance tax may be payable.