With the income tax compliance season about to get kick into full swing, taxpayers will begin to focus on the tax benefits associated with pension contributions when finalising 2018 tax liabilities and calculating preliminary tax payments for 2019. While there will be a lot of discussion around the tax savings available when making the pension contributions, there may not be the same time and consideration put into the taxation of pension funds over the longer term. As practitioners, we should be having conversations with clients on the tax treatment of their pension funds when they die or fall into ill-health.

What happens to a pension on death?

The tax treatment of the pension fund depends on whether the pension holder dies in-service or in retirement. Where the pension holder dies in-service and is a member of a company pension scheme, the maximum amount the pension scheme is permitted to pay out is four times the member’s final salary plus a refund of the additional voluntary contributions (AVC’s) paid by the member. These sums are paid directly into the estate of the pension holder without the operation of any withholding taxes. Where the holder of a PRSA dies in-service, the total PRSA fund is paid directly into the estate. Both sums are taxable on the beneficiaries under Capital Acquisition Tax (CAT) at 33 percent subject to group tax-free thresholds and reliefs.

Where the death of the pension holder occurs following the retirement of the pension, the tax treatment of the fund will depend on the options selected upon retirement. Where the policy holder opts to purchase an annuity for the life of the policy holder, the annuity will terminate upon death and no amount will be payable to the estate. On the other hand, if the policy holder opts to purchase a joint life annuity (holder and his spouse/civil partner) this will terminate on the death of survivor with no sum payable to the estate.

If on retirement, the policy holder opts to invest the pension fund (after any lump sum drawdown) into an approved retirement fund/approved minimum retirement fund (ARF/AMRF), the remaining value in the fund forms part of the deceased’s estate.

How is the ARF taxed on death?

The tax treatment of ARFs when the holder dies depends on who inherits the ARF and in what manner.

• If the ARF transfers into an ARF in the name of the holder’s spouse/civil partner, then no income tax or CAT is payable. However, the spouse will pay income tax on any withdrawals from the ARF.
• If the ARF is taken directly by the spouse/civil partner it will be treated as a taxable distribution and subject to income tax at the holder’s marginal rate in the year of death.
• If the ARF monies are inherited by the holder’s child, who is under 21 at the time of the holder’s death, then no income tax is payable, although CAT may be payable depending on the total amount inherited.
• If the ARF monies are inherited by the holder’s child, who is 21 or over at the time of the holder’s death, then income tax at rate of 30 percent is chargeable. However, CAT is not payable.
• If the ARF monies are inherited by any other person (not being your surviving spouse/civil partner or child) both income tax at the marginal rate (up to 40 percent) is payable on the withdrawals and CAT is also payable.

One of main advantages of holding an ARF over an annuity is that the remaining value in the fund will pass on death. However, the holder needs to be aware that ARF assets will pass into ‘the estate’ on death. The fact that the ARF gets paid into the estate can have serious implications;

a) Creditors:

If there are creditors of the deceased, one of the duties of the Executor or Administrator is to pay any valid debts of the deceased which are enforceable against the estate. In cases where the debts exceed the assets of the estate, it won’t matter who the holder left the ARF to in his/her will as the money could potentially go to the creditors.

b) No valid will:

Dying intestate can cause problems resulting in payments not going in line with what the deceased would have wanted and giving rise to potential tax inefficiencies. These could apply even if there is no ARF involved, however the inclusion of an ARF with its specific tax treatment, may potentially magnify these problems.

c) Will drafting issues:

To ensure that the intentions of the deceased are carried out, the will must be correctly drafted. ARFs should be specifically and clearly referenced in the will. Because of the special tax treatment of ARF, assets passing into an ARF in the name of a spouse/civil partner, it may be assumed that there is a semi-automatic passing of the ARF to the spouse/civil partner, i.e. that the spouse/civil partner ‘steps into the shoes’ of the original ARF owner. This assumption is incorrect and could lead to the assets falling under the ‘residuary clause’, which deals with the residue of assets not specifically dealt with in the will. This could mean that the ARF gets left to the children or to another beneficiary.

So whilst ARF holders may feel that they would like to make provision in their will for the proceeds of their ARF to be transferred into an ARF in the spouse/civil partner’s name (because this might be the most tax efficient), this might not necessarily be what the survivor wants at that time, and reluctantly will be forced down that path if that is what is in the will.

In general, once the ARF holder has provided that the ARF assets pass to the spouse/civil partner on death, it will be up to the surviving spouse/civil partner to decide to:

1. Set up an ARF in their own name and transfer the proceeds into this, or
2. If they have an existing ARF, can arrange for the proceeds to be transferred into this, or
3. Take the assets in cash (with tax deducted – treated as income of the deceased in the year of their death)

Where the ARF will pass directly to children who are over 21, it may be worth undertaking a cost benefit analysis of taking out a Section 72 policy (a Revenue approved life insurance policy) to cover the income tax liabilities which will crystallise for the children up the death of the holder.

When providing for the ARF in the will, consideration should be given to following key determining factors;

• The value of the ARF fund
• The relationship between the holder and the beneficiary of the ARF
• Values of other assets in the estate
• Availability of CAT group tax-free thresholds.

Tax implications on early retirement on grounds of serious ill-health (terminal illness)?

Where a member of an occupational scheme has been diagnosed with a terminal illness, the holder may be able to fully commute their pension benefits. Revenue will only allow commutation of the pension fund on these grounds where the member’s life expectancy is “measured in months rather than years”. The pension administrator must obtain sufficient medical evidence to support the claim.

In the case of a 20 percent director, Revenue must be notified and approve the claim for early retirement on serious ill-health grounds. This option is not available on PRSAs or personal pensions.

A claim on the grounds of terminal illness is payable in two parts. The first part is calculated with reference to the maximum retirement lump sum permitted under the scheme rules and is exempt from tax.

The balance of the fund is subject to tax at 10 percent and is deducted at source by the pension scheme administrator. The after-tax sum is paid directly to the member.

Conclusion

As with all matters of succession planning, the key is to plan for the future event and keep the matter under periodic review in light of any changes to tax legislation, upward or downward movement in assets values which will fall into the estate and the tax position of the beneficiaries to the estate.

Where the holder wishes to direct who benefits from the ARF asset, specific reference should be made to this in the will so that it does not inadvertently fall within the residuary clause. While there is the ability to make a claim under the serious ill-health option in an occupational pension scheme to fund living costs during the time of illness, this is not compulsory. Consideration needs to be given to all the options available to the pension member and the tax impact of the funds post his death.

Caroline McGrath is Tax Partner with BCA Chartered Accountants, Tullamore, Co Offaly.