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Ill-health and retirement options

Individuals unable to work due to a physical or mental medical condition can usually access their pension savings at any age. They don't have to be aged 55 or over.

HMRC recognises two situations where benefits may be taken early on health grounds. These are:

1. Ill-health - Where an individual is unable to continue doing their job for health reasons
2. Serious ill-health - Where an individual has a life expectancy of less than 12 months

Although the law allows this, pension scheme rules might not permit early retirement based on these definitions - they can set their own criteria. Potentially a scheme could, for example, only accept claims for specifically listed illnesses, or require that an individual is unable to carry out any occupation, not just their own.

Medical evidence

Before paying benefits on ill-health grounds, the scheme administrator must have medical evidence that the individual is (and will continue to be) incapable of carrying out their occupation because of physical or mental impairment and has actually stopped working. This could, for example, take the form of a letter or medical report from the individual's doctor that states the nature of the illness and their inability to work.

For an individual to qualify for serious ill-health benefits, the scheme administrator must have written evidence from a registered medical practitioner that the individual's life expectancy is less than one year.

Taking benefits in ill-health

Depending on the scheme rules, benefits may be taken in the same way as someone retiring on or after the normal minimum pension age. They will also be taxed in the same way.

The worse a client’s state of health, the more focus they could have on needing a lump sum. This could be used to:

• pay any costs incurred from medical treatment or from making home alterations
• pay off any remaining mortgage
• reduce or clear debts (credit cards, loans etc)

While some clients may need that initial cash injection, others may face a significant period of recovery or the possibility of never returning to work. This could make replacing the lost earnings, and providing a long-lasting secure income stream, their top priority.    

Money purchase schemes

All the normal options can be used to provide benefits on ill-health, subject to what the scheme allows - e.g. tax free cash plus flexi-access drawdown or annuity, an uncrystallised funds pension lump sum (UFPLS), or perhaps taken under the small (stranded) pots rules. It may also be possible to phase benefits.  

If an annuity is to be purchased, better rates may be available through providers offering 'impaired life' or 'enhanced' annuities.

The possibility of an improvement in health in future, with a return to working - perhaps in a different occupation - should be considered. Income drawdown could give the option to reduce (or turn off altogether) the level of income drawn if the client starts earning again in future.  

Defined benefit schemes

If pensions are paid early from defined benefit schemes, the scheme rules will determine how those benefits will be calculated.

Where the value of benefits is small, it may be possible to take them as a taxable lump sum under the small pots rules, or as a trivial commutation lump sum.

Special rules apply where the scheme includes GMP rights - these are guarantees that must be provided by defined benefit schemes as a condition of contracting out of the additional State Pension. The benefits can only be paid out early on grounds of ill-health where the revalued GMP promise is covered.

A scheme pension paid early on the grounds of ill-health can be reduced or stopped without incurring any unauthorised payment tax charges. This allows schemes to provide a level of pension that’s appropriate to the member’s capacity to do their job – for example, where a member recovers (or partially recovers) sufficiently to be able to return to work.

Taking benefits in serious ill-health

As well as the normal ill-health retirement benefit options, if someone has a life expectancy of less than a year, it may be possible for uncrystallised funds to be paid entirely as a tax free lump sum (known as a serious ill-health lump sum). Any benefits already crystallised will continue to be paid as a taxable income. This option could therefore appeal to both those above and below the minimum pension age of 55.

To qualify as a serious ill-health lump sum, all the following conditions have to be met:

• The scheme administrator has received written confirmation from a registered medical practitioner that the individual's life expectancy is less than a year
• The funds being paid as a serious ill-health lump sum are uncrystallised
• The individual has not used up all of their lifetime allowance (LTA)
• The lump sum payment extinguishes the individual's entitlement to uncrystallised rights under the arrangement
• The scheme rules allow it

Clients may not initially qualify for a serious ill-health lump sum, but it may become an option if their health deteriorates. If the client still holds uncrystallised funds, this could be part of a phased strategy if/when their life expectancy reduces.

With regard to defined benefit schemes, if the member is married or in a civil partnership, there will be restrictions placed on any GMP or Section 9(2B) rights as the scheme needs to retain sufficient of the pension fund to allow it to provide a survivor's pension. The balance of the benefits, if any, can be paid out as a lump sum.

The potential IHT trap

Whilst a tax free lump sum may appear very attractive to someone in serious ill-health,  care is needed. Whilst it will be paid tax free, that doesn’t necessarily mean there won’t be any tax consequences!
 
Anything left unspent would be within the individual’s estate and could be subject to IHT, if total assets exceed their nil rate band. Where IHT is an issue, and the funds are not needed, it may be better not to take the serious ill-health lump sum if the individual is under 75 because, following their death, the individual’s beneficiaries could receive the funds tax free.

If the individual died beyond age 75, the beneficiaries would pay income tax on any funds taken, which could be less than the IHT bill - this would depend on the size of the pension fund, how the payments were taken and the tax position of the beneficiaries.

Ill-health benefits and the lifetime allowance

Benefits taken early under ill-health are tested against the member's full LTA - it's not reduced as it would be for pensions taken early under a protected low pension age. For 2023/24 there is no LTA tax charge on the excess.

A serious ill-health lump sum paid before age 75 will be tested against the individual's LTA. For 2023/24 any excess over the LTA will be taxed at the member's marginal rate.

Ill-health benefits and the annual allowance

The onset of ill-health can impact on pension funding and the annual allowance.

Accessing pension benefits flexibly - for example, via flexi-access drawdown or UFPLS - will trigger the money purchase annual allowance (MPAA) which limits funding to defined contribution pension schemes to £10,000 per tax year and no ‘carry forward’ available.

For most, this may not be much of an issue because tax relievable contributions by an individual would be limited to £3,600 a year anyway if they no longer have any earnings. However, it could be an issue if there’s a chance of recovery and a return to work at some point in the future.

On the flip side, ill-health can, for some, open up the opportunity for additional funding as there are some annual allowance exemptions. There is no ‘pension input amount’ for an arrangement if, in the tax year, the individual:

• receives a serious ill-health lump sum from the arrangement, or
• becomes entitled to all benefits under the arrangement because of severe ill-health. This means that they’re unlikely to be able to work again in any capacity (other than in an insignificant way) before State Pension age.

Of course, this is only likely to be of benefit to those who already have significant earnings in the tax year that they become ill, or to business owners who could make a large employer contribution.

For more details on the annual allowance and MPAA, see our ‘Annual allowance ’ technical guide.

Transferring in ill-health

Individuals who want to take their benefits early under the ill-health rules may wish consider transferring if, for example, their existing contract doesn't offer flexi-access drawdown.

Transferring pension benefits normally has no inheritance tax (IHT) implications if the member is in good health. The transfer serves to benefit the member's retirement plans and not to benefit anyone else.

But doing it when knowingly in poor health is different. If the individual dies within two years, the pension transfer could have a value for IHT. HMRC may to take the view that part of the reason for the transfer was to benefit someone else.

For more details, please read the 'Pensions and IHT' technical guide.

Possible impact on State benefits

As part of any decision-making process into whether or not to use their pension savings, ill-health clients must also be mindful of any means-tested State benefits they could be entitled to due to their circumstances - for example, Universal Credit.

With the potential that some or all of any entitlement could be at risk should capital or income is accessed, it’s important to fully identify any impact. Clients may need to speak to their local benefits office to get confirmation of the position.

State Pension can’t be accessed early by those in ill-health. But National Insurance (NI) credits may be available - for example, to those receiving Universal Credit or Employment and Support Allowance (ESA) - which can boost the individual’s NI record for State Pension entitlement.