C3.02: DEATH & INCAPACITY BENEFITS

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1 C3.02: DEATH & INCAPACITY BENEFITS SYLLABUS Lump sum benefits on death Death before crystallisation Death after crystallisation Life assurance arrangements Payment of benefits Income benefits on death Definition of dependants Limitations Operation of annuity guarantees Effect on allowances Transitional protection Incapacity benefits Shortened life expectancy Waiver of contribution Tax treatment of waiver costs and benefits Lump sum benefits on death Lump sum death benefits often arise on the death of a member of a regulated pension scheme In some cases, the member will not have started to crystallise retirement benefits, but in others he may have crystallised some or all of his retirement benefits In most cases, it is only possible to pay a lump sum benefit if death occurs before the member has reached age 75 The exceptions to this arise where: - a trivial (less than 1% of the standard lifetime allowance) is paid to a dependant on the winding up of a scheme - a member dies whilst taking income by means of ASP (Alternatively Secured Pension) and there are no dependants, in which case a lump sum can be paid to a charity or be used to boost the funds of other members Death before crystallisation Under a PP or similar arrangements, if death occurs before crystallisation, there is commonly a return of fund (or in some cases, contributions, possibly with interest) which is available as a lump sum benefit The lump sum is known as an uncrystallised funds lump sum death benefit and must be paid out within two years of the scheme administrator becoming aware of the death (otherwise it would constitute an unauthorised payment) The payment is a BCE (Benefit Crystallisation Event) and triggers a test against the lifetime allowance of the deceased (or the remainder of the allowance if some retirement benefits have been crystallised under the same or other arrangements) If the lifetime allowance is not exceeded, the payment is free of tax, but if the allowance is exceeded, the normal lifetime allowance tax charge at 55% applies to the excess The liability for this falls on the recipient Where lump sums are paid under several arrangements, they are regarded as arising simultaneously and the tax charge is apportioned between them

2 In this circumstance, it may be appropriate to use the excess to provide an income benefit, the provision of which is not a BCE (see below) There would then be no lifetime allowance tax charge Death after crystallisation On death after benefits have crystallised under an arrangement, the position will depend on how income is provided If an annuity has been purchased, annuity protection (also called value protection) can be included, which operates in the same way as capital protection on a non-pensions annuity If protection is 100%, a lump sum is paid on death which represents the shortfall (if any) between the annuity instalments received and the purchase price of the annuity The payment is known as an annuity protection lump sum death benefit Protection at a level of less than 100% is permitted (but not more than 100%) Tax at 35% is deducted from the lump sum by the scheme administrator There is no further liability on the recipient, nor any possibility of the tax deducted being reclaimed, whatever the position of the recipient A similar provision relates to the provision of a pension protection lump sum death benefit where the member is provided with a scheme pension An unsecured lump sum death benefit can be provided where unsecured income by way of income withdrawals was being taken at the time of death, and represents the residual fund Tax at 35% is deducted from the lump sum by the scheme administrator Note that this treatment applies even if no income was actually generated because withdrawals were set at a zero level If unsecured income is being taken partly by means of a short term annuity, no lump sum benefit is payable under the annuity itself (though a guarantee period may apply see below) In such a case there will generally be a residual fund which has not been used to purchase the annuity and this could be used to provide an unsecured lump sum death benefit, as described above If death occurs during ASP, the individual will necessarily be over the age of 75 and no lump sum payment is generally permitted as discussed above Death during ASP is discussed in more detail in a separate syllabus area Life assurance arrangements In the past, it has been possible to arrange term assurance written under PP rules, with tax relief on the premiums paid by individuals, at their highest rate(s) of tax This facility has now been withdrawn for new policies Relief continues to be available for policies applied for before 14 December 2006 and in force by midnight on 31 July 2007, provided that they are not amended to increase either the cover or the term except through the operation of a policy option (eg indexation) Where relief is available, the payment of benefits on death (assuming they are paid as a lump sum) would be a BCE and would trigger a lifetime allowance tax charge Benefits paid in lump sum form would not be subject to income tax Life policies of this sort can be assigned or written into trust in the same way as any other life policy

3 Payment of benefits Where benefits are subject to a master trust or similar arrangement, lump sum death benefits are usually payable at the discretion of the trustees or scheme administrator The member is invited, usually at outset, to advise the trustees or scheme administrator who he would wish to benefit This guidance is not binding on the trustee or scheme administrator The member can change the guidance at any time As a result of this process, the benefit is generally payable outside of the estate, without need to await probate, and free of inheritance tax (IHT) liability Freestanding life assurance policies can be written in trust and should therefore also avoid IHT There are no restrictions from an HMRC point of view on who can receive lump sum death benefits and in particular, potential recipients are not restricted to dependants It is possible for the benefits to be paid to individuals, companies, trusts or charities for example The scheme rules will specify the category of potential beneficiaries, which usually includes a spouse, registered civil partner, children (of any age), dependants, anyone who is a beneficiary under the member s will, and anyone nominated by the member Income benefits on death Income benefits can be provided for dependants on the death of a member, whether before or after benefits have crystallised Payment of income benefits to dependants is not a BCE Income benefits (unlike lump sum benefits) cannot be paid to anyone other than a dependant without giving rise to an unauthorised payment with the attendant tax charges Income benefits may be provided by means of a scheme pension, an annuity, unsecured income (if the recipient is under 75) or ASP (if the recipient is over 75) If income is provided for a dependant under age 75 on an unsecured basis, it must be secured before the recipient reaches age 75 Several dependant s pensions may be paid to different people (within the definition below) and each may be in a different form Income benefits are taxed as the earned income of the recipient under PAYE Definition of dependants The definition of dependants automatically includes a spouse, registered civil partner and children under the age of 23 Also included is any other individual who was dependent on the individual, or was financially interdependent with the individual Limitations Where the dependant is a minor, income benefit must cease by age 23 at the latest, unless the child is dependent on grounds of disability Note that there is no extension to this age on grounds of continuation of full-time education (as was allowed under pre A-Day rules) Spouse s or civil partner s benefits can continue for life

4 Alternatively, they can be provided on the basis that they cease on entering into a new marriage or civil partnership if the scheme so chooses (this would be unusual in the context of an individual arrangement) However, they cannot include a guaranteed minimum payment period, nor value protection Operation of annuity guarantees The individual s pension benefits can be subject to a guaranteed minimum payment period, which must not exceed 10 years from the date when the income was secured eg by annuity purchase The ten year guarantee can be provided even if purchase of the annuity was preceded by a period of taking unsecured income, by income withdrawals, or by short term annuity (even if the short term annuity was itself guaranteed) If the individual dies during the guarantee period, the income continues until the end of the guarantee period, and the right to this income can be assigned to the beneficiaries of the individual s estate Payments under such a guarantee cannot be commuted for a lump sum They are taxed as the earned income of the recipient under PAYE Note that it is not possible for an annuity to include both value protection and a guaranteed minimum payment period Effect on allowances As discussed, lump sum benefits paid from uncrystallised funds on death trigger a test against the deceased member s remaining lifetime allowance Lump sum benefits paid from crystallised funds do not (though a 35% tax charge will arise) Payment of income benefits to dependants does not trigger a lifetime allowance test, nor is there any tax charge against the amount used to provide such benefits (although the income itself is taxable as earned income) The receipt of dependant s benefits does not affect the recipient s annual or lifetime allowances in any way Transitional protection Primary protection may be affected by lump sum death benefits because their value whilst the member is alive is generally zero, but on death, the benefit can be substantial There was therefore a concern that the provisions as originally proposed, could have an adverse effect because the amount protected would have reflected the value of pension benefits only To deal with this, changes were introduced in the Finance Act 2006, which came into effect from 6 April 2006, the start of the simplified regime Essentially, on death, the primary protection factor is increased to take account of the value of death benefits which were arranged prior to 6 April 2006, calculated as if they had become payable on 6 April 2006 The cover must generally continue under the same policy and the terms must not be significantly varied after 5 April 2006 Enhanced protection is lost if a new arrangement is set up to provide death benefits (other than where it is set up solely to receive a transfer value) However, continuation of an existing policy generally would not

5 Contributions can be paid to maintain existing life cover without losing enhanced protection, subject to a number of conditions The life policy must have been in place before 6 April 2006, and provide death benefit only In the case of money purchase death benefits, the cover must not be varied to increase benefits on or after 6 April 2006 In the case of a defined benefit lump sum death benefit (generally a salary linked arrangement), the cover can increase by the greater of 5% pa and the increase in RPI Incapacity benefits Individuals retiring through ill-health can take benefits without being subject to a minimum age requirement However, there is a good chance that the income available will be very small, because the fund has not had as much time to build up as had been expected The individual must be diagnosed as incapable of continuing in his current occupation, and must cease that occupation The scheme administrator must obtain medical evidence confirming the ill-health Details of any ill-health benefits under individual arrangements do not need to be submitted to HM Revenue & Customs (HMRC) Except where life expectancy is less than one year (see below), benefits are provided in the normal form, with a maximum of 25% of the value available in the form of tax free cash Benefits are tested against the lifetime allowance (or remaining allowance) in the normal way Shortened life expectancy Under the simplified regime, benefits may be fully commuted for cash if life expectancy is less than one year In such cases, the scheme administrator must obtain medical evidence to support the shortened life expectancy Benefits are subject to testing against the lifetime allowance (or the remaining allowance) in the normal way Provided they are within the lifetime allowance (or the remaining allowance), the whole of the benefit is tax free Otherwise the lifetime allowance tax charge applies in the normal way Before A-Day, ill-health commutation was available only under occupational schemes, and not personal pensions or retirement annuities; also, part of the benefit under occupational schemes was taxable, so the new regime is considerably more liberal Waiver of contribution Waiver of contribution (also known as Pension Contribution Insurance or PCI) can be provided under a separate arrangement, but with no relief on the cost Medical evidence is generally required if the individual wants to include waiver The waiver can come into effect if the member loses some or all of his usual income either through ill-health or redundancy, though there is little sign of the latter being available in the market place As with Income Protection Insurance (IPI, also known as Permanent Health Insurance or PHI), there is generally a deferment period before the waiver starts to operate

6 There also needs to be some means of replacing income up to retirement, usually an IPI arrangement The IPI income ceases at expected retirement age, and then the PP can provide retirement income Tax treatment of waiver costs and benefits Under current rules, waiver cannot be included within the PP, but must be provided under a separate policy The cost of the waiver does not qualify for tax relief, nor does it count towards overall contribution limits Contributions funded by the waiver do qualify for relief in the normal way PP arrangements in existence before 6 April 2001, and including waiver, or the option to introduce it, can continue and are subject to the pre-2001 rules Under these rules, the cost of the waiver qualifies for relief and is counted towards the individual s contribution limits But, under the pre-2001 rules, contributions waived do not qualify for tax relief (they are waived, not paid)