Can you benefit from the 2015 changes?
As introduced by the Budget in March 2014, the Government unveiled plans to completely overhaul the UK’s pension system.
Since April 2015, from age 55, whatever the size of a person’s defined contribution pension pot, they can take it however they want, subject to their marginal rate of income tax in that year.
25% of their pot remains tax-free and individuals can benefit from increased flexibility. People who continue to want the security of an annuity will be able to purchase one and people who want greater control over their finances can draw down their pension as they see fit.
Those who want to keep their pension invested and draw down from it over time will be able to do so.
Since then, savers have had freedom to do as much or as little as they want with their pension. But what do these freedoms mean in practice?
What are the main changes?
- Allow all of the funds in a money purchase arrangement to be taken as an authorised taxable lump sum, removing the higher unauthorised payment tax charges.
- Increase the flexibility of the income drawdown rules by removing the maximum ‘cap’ on withdrawal and minimum income requirements for all new funds from 6 April 2015;
- Enable pension schemes to make payments directly from pension savings with 25 per cent taken tax-free (instead of a tax-free lump sum);
- Ensure that individuals do not exploit the new system to gain unintended tax advantages by introducing a reduced annual allowance for money purchase savings where the individual has flexibly accessed their savings;
- Increase the maximum value and scope of trivial commutation lump sum death benefits;
- Enable persons other than dependants to inherit unused drawdown funds and provide that where the death occurred before age 75, lump sum death benefits and drawdown pension from these funds can be paid tax free, subject to the member having sufficient available lifetime allowance;
- Allow annuities paid to a beneficiary on the death of the member before age 75 to be paid tax free.
What does this mean in practice?
Savers have always had the freedom to take 25% of their pension in a tax-free lump sum, but have then generally been herded into buying an annuity with all of the rest of the money. From April 2015, from age 55, whatever the size of a person’s defined contribution pension pot, the Government proposes that they’ll be able to take it however they want, subject to their marginal rate of income tax in that year. 25% of their pot will remain tax-free and individuals will benefit from increased flexibility. People who continue to want the security of an annuity are now able to purchase one and people who want greater control over their finances can drawdown their pension as they see fit. Those who want to keep their pension invested and drawdown from it over time are now able to do so.
In addition, savers over the age of 55 are given the option of taking a number of smaller lump sums, instead of one single big lump sum, and in each case, 25% of the sum is tax-free. However, as pension advisers are saying, this change was widely anticipated as an essential part of the new pension freedoms, and was actually already in place in the form of “phased retirement” or “vesting” under the old system.
How does this benefit me?
The main beneficiaries of this are those who have built up relatively large pension pots, who will be using this freedom to avoid paying 40% tax when they draw it down under the new freedoms. For example, if you have a £200,000 pot, you could cash it in and have £50,000 tax-free, but the remaining £150,000 would be liable for tax. This means that, depending on the individual’s personal allowance and other earnings, a lot of it will be swallowed up by 40% tax – as much as £53,600.
But if the person decides to take the pension instead as £50,000 each year for four years, then each year he or she will receive £12,500 tax-free and be liable for income tax only on the remaining £37,500, which could be as low as £5,500. So instead of paying more than £50,000 in tax, the person pays around £22,000.
I only have £40,000 in pension savings. What does it mean for me?
A £40,000 pension pot is actually about average for those people in the UK who have “defined contribution” schemes. If you take the lot immediately on retirement, and have no other income, then you would receive a £10,000 tax-free lump sum and then be liable for tax on the remaining £30,000 – which would be around £4,000.
If you take it at £10,000 a year over four years, then each year you’d get a tax-free lump sum of £2,500, while the remaining £7,500 will be liable for tax. Given that the personal allowance is £10,000, that would suggest you’d be getting your hands on the cash entirely tax free. But remember, HMRC will also be including your State Pension in the calculation. If you are drawing that as well (and you don’t have to, you can defer it for a number of years) then that income will be added into the tax equation.
Can I effectively use my pension as a bank account?
Yes. The money you have saved will sit in a pension pot for you to access whenever you want from age 55, subject to your marginal tax rate. The costs of doing so however are quite high, and there are likely to be charges to pay.
When can I start doing this?
These changes came into force in April 2015.
What age do I have to be?
Currently you have to be 55 or over to access your pension. If you try to take the money before that age, the old tax rules apply – which mean that a minimum 55% is taken by HMRC. Younger workers, though, should watch out for a rise in the 55-year-old threshold for accessing their money. The thinking in pension circles is that the government will tie pension’s freedom to within 10 years of retirement age – which as it rises to 67 and 68, would suggest you won’t be able to access the money until 57 or 58. But there is no formal announcement on this.
Do I have to retire to take the money?
No. You can be 55 years old and in work, receiving a salary, and be allowed access to your pension. So if, for example, you have a small DC pension pot from a former employer and you want the money, you can take it as a single lump sum or draw it down over several years, even if you are in work and paying into your company’s pension scheme. The same rules apply – 25% of each drawdown will be tax free, with the rest liable for tax at your marginal rate. So if you are earning £50,000 a year, then it’s not that great, as each bit of money will be taxed at 40%, but if you are, say, working part-time, and pay 20% tax, then it could be a useful boost to your income.
I have a Defined Benefit pension, what do the changes mean for me?
The new pension flexibilities do not apply to Defined Benefit pensions therefore your flexibility has not changed. However, as before you still have right to a Cash Equivalent Transfer Value from your defined benefit scheme. This means that if you wish you could transfer the cash equivalent value of your pension to a Defined Contribution pension. This would then afford you the same flexibilities as discussed above. The transfer of a defined benefit pension to a defined contribution pension is not a decision that should be taken lightly as you are giving up guaranteed benefits. However for certain people this could be an appropriate option.
What circumstances might I consider transferring my Defined Benefit pension?
- If you are single/divorced/widowed
- If you are in ill health
- If your income requirements are not fixed and are likely to fluctuate
- If you have a requirement for a significant one off lump sum
If you would like to discuss why the above may be reasons to transfer out of a defined benefit pension, then please do not hesitate to contact us.
Can I pass on my pension to others without paying any tax?
Yes. Instead of paying the 55% rate of tax when passing on your pension, people who die under 75 with defined contribution pensions can from April 2015 pass on any unused pension as a lump sum to a person of their choice tax free.
At the Autumn Statement 2014, the Chancellor also announced that after April 2015 payments from certain kinds of annuities that pay out income after you die (joint life and guaranteed annuities) would be tax-free when paid to a beneficiary, if the original policyholder dies below age 75.
For people who die over the age of 75 with unspent defined contribution pensions, they can pass this on to a person of their choice who will be able to take it as a lump sum taxed at 45% or as income and pay their normal rate of income tax.
Will my pension pot run out?
Pension drawdown historically has been deemed as a high risk strategy, reserved for higher risk tolerances and people with significant sums of money. The flexibilities offered have not changed the risks involved, only allowed more people to access their pensions. As you are drawing directly from the pension pot, there is a chance that you could withdraw more per annum than any growth can account for and your pension will go down in value, it could even be exhausted completely. However, this is deemed to be an acceptable option in certain circumstances. If you simply need a once off lump sum, then you can take the entire pension in a single lump sum (subject to tax) and your pot will have no value after.
Planning the flow of cash I require is quite important then?
Without a doubt, if you access your pension flexibly, cash flow planning becomes the foremost concern and will help you to understand your requirements for the future and how decisions made today can affect tomorrow. We have a client friendly cashflow planning tool designed to help client’s understand how their cashflow may look in the future which can be reviewed annually to keep on top of your income needs.