Retirement Planning:
Good News for Pensions

New rules set to boost your pension pot

Good news – the Government has just announced new rules that will make pensions even more attractive from the start of the new tax year on April 6th.

These changes come on top of the new pension contribution rules which we welcomed with open arms because:

• Higher-rate tax relief on pension contributions (40% tax relief) has not been scrapped, despite numerous predictions that it would be.
• Those earning over £150,000 will enjoy the maximum 50% tax relief (scuppering the previous Government’s plan to limit tax relief to 20%).
• The maximum annual pension contribution (annual allowance) has been reduced but is still very generous – £50,000 per year.
• Any unused allowance from the previous three tax years can be carried forward, making for a maximum contribution of up to £200,000.

Apart from tax relief on contributions, pensions enjoy two additional tax breaks:

• Tax-free investment growth
• A tax-free lump sum (25% of the fund) available from age 55

You have to pay income tax on the remaining 75% of your pension pot when the money is taken out BUT a significant chunk could be tax free each year thanks to your income tax personal allowance, with the remainder often taxed at just 20% (most retirees are basic-rate taxpayers).

Taking all the tax breaks together, our calculations show that someone who contributes to a pension plan could end up with 40% more income after tax than someone who invests in ISAs, that other well-known tax shelter.

There is no denying that pensions are very attractive tax shelters but there has always been one major problem: Getting your hands on the money!

Fortunately, this is all about to change. From April 6th it will be much easier for some (but not all) savers to tap their retirement savings.

Before Age 55
At present you cannot withdraw any money from your pension plan until you reach age 55.

This rule is supposed to be for our own good, protecting us weak wastrels from raiding our retirement savings to pay for a new telly or a fortnight in Benidorm.

In reality, there are times when even financially conservative individuals may want to tap their retirement savings early.

An obvious example would be to pay for family medical expenses. Other reasons may include paying education expenses or avoiding bankruptcy or home repossession.

As it happens, there are a couple of exceptions to the no withdrawals before age 55 rule… but if you are squeamish you should look away now.

Firstly, all pension savings can be withdrawn as a tax-free lump sum if you suffer from “serious ill health” (the polite way of saying you have less than a year to live).

You can also withdraw money from your pension plan if you suffer from “ill health” (i.e. you are not about to die but are too sick to work again).

Fortunately, the Government is likely to make it easier for individuals to tap their pension savings for other reasons in the near future, hopefully following the much more flexible approach adopted in the US (Americans can withdraw money from certain retirement accounts at any time and for any reason).

In December the Government released a consultation document on early access. Nothing has been decided yet but there will hopefully be a change to the rules at some point this year.    

Getting Money Out After Age 55
When you reach age 55 you can either keep your money invested tax free in your pension plan or start withdrawing it.

If you want to start withdrawing it you can take 25% as a tax-free lump sum but the remaining 75% can only be taken out gradually using either:

• An annuity (a guaranteed income for life, purchased from a life insurance company), or
• Income drawdown

Annuities are often the best bet for those who need to maximise their retirement income. But many people despise them because the rates have plummeted in recent years and the pension company keeps your money if you die early, which means nothing can be left for your children or other relatives.

That’s where income drawdown comes in.

Income drawdown applies between the ages of 55 and 75 and lets you keep your retirement savings invested tax free and pay yourself a flexible income.

You don’t have to withdraw a penny but if you need a lot of income you can pay yourself up to 120% of the annuity payable to a person of your age.

Age 75
When you reach age 75 the rules become stricter.

You have to withdraw at least 55% of the annuity payable to a 75 year old. This means you have to withdraw money even if you don’t need it.

On the other hand, you cannot withdraw more than 90% of the annuity payable to a 75 year old. This means you may not be able to withdraw as much money as you would like.

(The 75 age limit was recently increased to 77 under certain limited circumstances but I will ignore that for the purposes of this article as it confuses matters and is only relevant to a few individuals.)

Change Ahoy!
All this is changing from April this year. There will be just one set of rules for all individuals over age 55.

However, the new rules will discriminate between the wealthy and the not-so-wealthy.

Pensions will become a lot more attractive to wealthy individuals… and a bit more attractive to everyone else.

From 6th April you will have three choices when you reach age 55:

• Buy an annuity
• Capped drawdown
• Flexible drawdown

BUT flexible drawdown will not be available to everyone.

‘Capped drawdown’ is similar to current income drawdown: You don’t have to withdraw a penny but if you need income you can pay yourself up to 100% of the annuity payable to a person of your age (previously 120%).

This means those aged under 75 can withdraw less money than before; those aged over 75 can withdraw more (previously 90%).

Those over age 75 will now be able to keep their retirement savings invested tax free for as long as they like. This change should appeal to those who have illiquid assets in their pension pots, e.g. commercial property.

The Rolls Royce of Pensions
‘Flexible drawdown’ doesn’t place any limits on withdrawals. In other words, when you reach age 55 you can extract ALL of your pension savings in one go as a lump sum. The first 25% will be tax free as before; the remaining 75% will be subject to income tax.

To qualify for flexible drawdown, however, you have to prove that you have other pension income of at least £20,000, for example from an employer’s pension, state pension, or personal pension annuity.

Based on current annuity rates for a 65 year old man, someone with a state pension would need other pension savings of around £200,000 to generate total pension income of £20,000 and qualify for flexible drawdown on their remaining retirement savings.

Although you will be able to withdraw all of your surplus retirement savings in one go there are two reasons why it may be more tax efficient to stagger your withdrawals:

1. Pension withdrawals are subject to income tax. Most retirees are basic-rate taxpayers but a big pension withdrawal could push you into the 40% or 50% tax band.
2. Pension investments grow tax free; investments outside a pension are generally taxed.

Tax-Free Retirement in the Sun
UK income tax is usually deducted from your pension at source but if you live in a country which has a double taxation agreement with the UK it may be possible to receive your UK pension without any tax deducted.

Income tax will be payable in your new country of residence, however this may be at a rate far lower than that levied in the UK. Your pension may even be exempt from tax altogether!

Using the new flexible drawdown rules it may be possible to have a large lump sum paid out tax free while you are non-resident.

The new flexible drawdown rules state that you will be taxed on all withdrawals of flexible drawdown pension if you return to the UK within a five year period. However, if moving abroad for a period is something you want to do anyway, it may be a way to extract a significant portion of your pension savings as a tax-free lump sum.

In summary, pensions have become more attractive tax shelters following a raft of recent announcements. You may want to consider upping your contributions.

Pensions & Inheritance Tax
The new rules could also make pension plans useful inheritance tax shelters for certain individuals.

If you die before age 75 and before taking any money out of your pension (including your tax-free lump sum), your pension pot can be passed on free of tax, including inheritance tax.

This was actually the rule before the recent changes and it will continue to apply.

From 6th April, if you die after you have started making withdrawals from your pension plan, or after age 75, the remaining money can be passed on, but there will be a 55% tax charge.

Now you may think 55% is steep but previously the maximum tax charge was 82%. The new 55% tax is supposed to simply recover the tax relief added to your pension pot over the years and is not really an inheritance tax charge.

Example
Johnny invests £1,000 in an ISA. After 20 years the fund has grown to £3,869. He also invests £1,000 net of tax relief in a SIPP. Thanks to income tax relief at 40%, his actual contribution is £1,667. After 20 years the fund has grown to £6,450.

If he dies and we assume his nil rate band is used up with other assets, he faces a 40% inheritance tax charge on his ISA and a 55% recovery charge on his SIPP.

After deducting these taxes, his ISA fund will be worth £2,322 and his SIPP will be worth £2,903 – i.e. 25% more. This is why a pension plan could be a useful inheritance tax shelter.

Finally, if you die after you start withdrawing benefits you can escape the 55% charge if your money is used to provide a pension to your spouse or a dependant.