New Pension Freedom

 October 21, 2014
 

Since the Budget 2014, there have been a series of announcements and legislative changes that constitute the most radical changes to UK pensions ever introduced. Having read a number of inaccurate articles online and in the press, and other summaries that are too complex, I have not yet seen a simple summary of the new key aspects of the changes that is easy to understand. I have therefore attempted to do this below.

Retirement Options

There are two main types of pension scheme: Defined Contribution (DC) and Defined Benefit (DB). A Defined Benefit pension is also known as final salary. The new Pension Freedom changes do not fundamentally have any impact in the way in which you can draw your pension from a DB scheme. The changes relate to Defined Contribution schemes, such as Personal Pensions, SIPPs and occupational money purchase schemes.

At retirement under a DC scheme, provided the scheme rules have allow it, you have the following options (all examples based on a £400,000 SIPP), assuming annuity purchase is not appropriate:

1. Take the whole pension fund as a lump sum.

  • The first 25% of the fund value will be tax free and the balance will be taxed as income in the year you take it.
  • For example, you would take £100,000 tax free, but the remaining £300,000 would be added to your other income and taxed as pension income, some of which would be taxed at a top rate of 45%.
  • Unlikely to be advisable.

2. Take the tax free lump sum of 25% and draw the balance as a taxable income, with no annual income limit.

  • Take the 25% tax free lump sum, then make regular withdrawals from the residual fund, in much the same way as under the current drawdown rules.
  • However, there will no longer be any income limits or income reviews, unless you are already in Capped Drawdown under the old rules.
  • For example, you could take £100,000 tax free, then draw down 5% per annum from the residual £300,000, giving you an annual before tax income of £15,000.

3. Take ad hoc withdrawals using your tax free lump sum

  • Each year, you could take withdrawals from the tax free lump sum entitlement.
  • For example, if you need income of £20,000 per annum, you could withdraw this amount each year from the tax free lump sum element until it is depleted.
  • Once 25% of the fund value has been taken as a tax free lump sum, any further withdrawals will be entirely taxed as income.
  • Therefore, after depletion of the tax-free cash, a higher gross amount would need to be withdrawn to get the same net £20,000 per annum.

4. Take ad hoc withdrawals using a combination of tax free lump sum and income

  • Under the new rules, each ad hoc withdrawal can be made up partly of tax free lump sum and partly of taxable income.
  • For example, if you withdrew £20,000, this could be formed of 25% tax free lump sum (i.e. £5,000) and the balance of £15,000 as taxable income.
  • In this example, a basic rate taxpayer would receive £17,000, which is an equivalent tax rate of 15%.
  • This is the approach I favour, as it is spreading the tax liability over the course of your retirement. However, it depends on your tax status and it may be better to defer any income tax until later.

Death Benefits

The other significant and well publicised change relates to the change in taxation of pension death benefits in drawdown.

If you die before age 75, then whether you have crystallised (i.e. started drawing down) your pension fund or not, your fund will be payable to your nominated beneficiary. The beneficiary can ether take the full benefit as a tax free lump sum or choose to keep it invested in a pension fund.

For example, a married 65 year old male dies with £400,000 in a SIPP. He nominated his wife as the beneficiary and she is 60 years old. She can take a tax free lump sum of £400,000 as cash. But what would she do with it? It would form part of her estate and ultimately in many cases would need to produce income.

A better option might be to keep it invested in a pension fund.  It then remains outside of her estate and she can make tax free withdrawals. She can then nominate their children as beneficiaries, and they can then take tax free withdrawals from the pension fund after her death. The exact tax treatment on second death is however yet to be confirmed in the rules.

If you die after age 75, the rules are different. Again, it does not make any difference whether your funds are crystallised or not, the tax treatment is the same. The main difference to the treatment on death before age 75 as opposed to death prior to 75 is that any withdrawals the beneficiary makes from the pension fund will be subject to income tax. There is still no tax charge applied to the fund at the point of death.

For example, a married 80 year old female dies with £500,000 in her SIPP. She nominated her husband to receive 50% and her children 25% each of her SIPP. The beneficiaries could take the full fund as a cash lump sum, but the lump sum would be added to their income and taxed accordingly.

A better option again might be to keep the money invested in a pension fund. Each beneficiary can use any remaining Basic Rate tax allowance to withdraw the money at a lower rate of tax, or they could keep the fund invested for their own children.

The previous rules in the above examples could have resulted in a 55% tax charge, so this has made investing in a pension significantly more attractive.

Annual Allowance

The Annual Allowance is a cap on contributions that can be made into a pension before tax charges apply to contributions. The allowance for 2014/15 is £40,000, but I expect this to reduce, regardless of the election result.

If you start to draw down from your pension after April 2015, you will be subject to a reduced Annual Allowance of £10,000 per annum. However, if you take action before April 2015, you can maintain an Annual Allowance of £40,000.

Summary

I hope the above is useful. Overall, I personally think that the new flexibility is hugely positive and removes illogical barriers from the pension system. Ultimately, this will hopefully make it more attractive to save into a pension. By removing the key barrier, which was restriected access, investors should feel more comfortable investing in a pension, which remains the most tax efficient long term savings vehicle.  My suggestion is to maximise contribution in this financial year to benefit from the £40,000 annual allowance and Higher Rate tax relief, as I am not sure how much longer these benefits will be available.

The key message is that although there is now greater choice, there is a greater need for advice. Choosing the right option is far from straightforward. If you are already in retirement, it is key to review your strategy completely in light of these changes.

David Penney APFS

Chartered Financial Planner

21st October 2014