Pension income – making the most of it
As people were preparing for ‘pension freedom’ from 6 April 2015, the Budget brought yet more changes to pension planning with a proposed cut in the lifetime allowance from £1.25 million to £1 million from April 2016. The lifetime allowance is effectively the maximum amount you can hold tax-efficiently in pensions.
The change will come with a new set of transitional provisions to protect people whose pension rights are already valued at over £1 million.
From April 2018, the lifetime allowance will be index-linked – if the rules aren’t changed again.
At current rates, £1 million will buy an index-linked pension with spouse’s benefits of about £27,000, roughly equal to national average earnings. With further reductions to tax relief on pension contributions likely over the next few years, this could be a good time to maximise payments into pension plans while you can still claim tax relief on up to £40,000 a year at your highest rate. But you should also consider using other tax-efficient investment opportunities, such as ISAs, to provide for your retirement.
Buying a pension annuity has become much less popular in recent years, and since 6 April 2015 it has become much easier to draw from pension savings in a more flexible way. However annuities should not be dismissed entirely because they are the only way to guarantee a lifetime income no matter how long you live.
Drawing income directly from your pension fund has several advantages, but it involves risks.
If investment returns are poor in the future, your income could be reduced or you could even run out. The money might have to last for a long time. A significant number of people now in their 60s can expect to live well into their 90s and possibly even beyond.
The new pension rules allow a combination of income drawdown and an annuity. You could use part of your fund to buy an annuity, ensuring an income for life to pay basic bills, but keep the rest invested to boost overall returns, hopefully, and ensure your beneficiaries inherit in the event of early death. Or you might delay buying an annuity until later, if you do not need the income yet.
If you opt for income drawdown, you should be aware of the tax implications.
The most important is to remember that normally only 25% of your pension can be taken tax free.
The rest will be taxed as your income as you withdraw it, at 20%, 40% or 45% depending on the level of the withdrawal plus your other income in the tax year.
There are two methods of income drawdown, both of which allow you to draw any amount you wish.
Flexi-access drawdown normally enables you to withdraw (or crystallise) your tax-free lump sum, leaving the balance of your fund invested.
You can draw this as a regular amount or a lump sum, but there is usually no point in drawing from the tax-free environment of the fund sooner than you need it.
You can take funds out of your pension and invest into it in the same tax year. As long as you only crystallise the tax-free element, you can continue investing the full £40,000 annual allowance into pensions. However once you start drawing income, your annual allowance for contributions drops to £10,000.
The other form of income drawdown is the generally less flexible ‘uncrystallised funds pension lump sum’ (UFPLS).
When a lump sum is drawn in this form, 25% is paid tax free and 75% is taxed as income. The balance of the fund stays invested. You can take a series of UFPLS payments, each of which is treated as a mix of 25% tax-free cash and 75% taxable funds. As soon as you take a UFPLS, your annual allowance drops to £10,000.
It is essential to take professional advice before you make any decisions. Drawing a substantial sum from your pension early presents risks. Some schemes may not offer pension freedom, in which case you will have to change provider. There are additional considerations if you are in a final salary scheme. Get in touch with us if you need help.
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– Taking money from a pension – watch for tax
– PENSIONS: HMRC guidance available on new pensions
– Pensions – How to apply to protect your pension tax allowances