Pensions – Are They Back on the Map?

Pension Planning

For many years, pensions had a bad press and many people gave up putting money aside for their retirement in the form of pension plans, choosing instead to look at other ways of providing for a “retirement pot”, be it property, direct equity portfolios, ISA’s etc.

Since the new pension freedom rules were introduced a few years ago, which increased significantly the flexibility around personal pensions (especially the drawing down in retirement), personal pension plans are making a comeback and are once again becoming an integral part of retirement planning.

So, let’s look at the “pension freedom” rules: –

When you’re 55 you can access your personal pension plan, and the best part? You can take as much or as little as you like. Usually 25% of the fund can be taken tax free but any amount taken above this is taxed as income.

Under the new rules, one or more of the following products can be used to access your pension:

  • Flexi-access-drawdown
  • Uncrystallised funds pension lump sum (UFPLS)
  • Lifetime annuity

Flexi-access-drawdown allows you to take your entire tax-free cash lump sum and leave the rest invested in a drawdown product that can be accessed later

UFPLS allows you to take the tax-free cash lump sum in stages instead of in one go. Like drawdown you can make withdrawals as and when you want to, but each withdrawal is made up of part tax free cash (25%) with the balance taxed as income.

Annuities – these have always been available but can be poor value as although they provide a guaranteed income for life, the annuity rate has reduced significantly over the past 20 + years. The 25% tax free cash can still be taken as a lump sum, with the balance of your fund being used to purchase an annuity. They do sometimes have a place in old style retirement contracts that may have guaranteed annuity rates within them – these could be as high as 12% per annum so if you do have any old-style retirement contracts it is always advisable to seek advice from an independent Financial Adviser to check this out for you.

To summarise, pension freedom changes have brought flexibility and control to retirement pension planning that was only previously available to individuals with large pension funds who could access retirement drawdown products.

Tax on pension withdrawals

Although you can take 25% of your pension savings as a tax-free lump sum, the balance is taxed as income, including the original contributions paid. This “sting in the tail” is the price to pay for the tax relief received on the contributions paid into the plan and the tax-free growth which the pension fund enjoys.

Ideally if you can secure higher rate tax relief on the contributions paid into the pension plan but only pay basic rate tax on the income when you draw it in retirement, you will still be significantly better off than saving via an ISA for example, and even at basic rate relief on the contributions, this “boost” from the tax man still means you should be better off than a straightforward ISA route. Retirement planning is about getting to a pot of money that you can access in retirement – Pensions and ISAs are just two of the vehicles to use to get to this “pot”.    

Leaving your pension to your family

The pension freedom rules also brought about significant improvements to the position around death benefits. Prior to 5th April 2015, pension funds were heavily taxed on death, with the fund suffering a 55% death tax charge!

The new rules brought with them the ability to pass on your pension pot to your family.

Death before age 75 –

Your pension savings pot (or anything remaining in a drawdown plan if you are drawing the pension benefits) can be paid to your nominated beneficiaries free of tax – they can have it all as a lump sum (if taken within 2 years of death) or they can continue in drawdown and make tax free withdrawals when they like – they don’t have to reach age 55 to be able to do so.

The pension pot does not form part of your estate for Inheritance Tax (IHT) purposes, so this makes pensions a very effective estate planning tool. In fact, it may be worthwhile for wealthy retirees to leave the pension pot as the last call for any income requirements because of the IHT advantages this will bring.

The important issue (and we cannot stress this enough) is to make sure the nominated beneficiary form that sits with the pension policy is up to date and is reflective of your wishes. The Pension trustees will usually pay benefits in accordance with the Nomination Form, so it is imperative to check this with your pension provider.

Death after age 75 –

Your nominated beneficiaries pay income tax on the money they withdraw from your pension pot. The money can stay invested and grow tax free and it still doesn’t form part of your estate for IHT purposes.

Tax Planning –

With the abolition of the 55% death charge, combined with the exemption from IHT, pension pots are now a powerful vehicle for passing wealth down the generations.

The assets in the plan continue to grow tax free and the only tax payable by your beneficiaries will be income tax on any withdrawals they make and they won’t pay any tax on withdrawals if you die under the age of 75.

Your nominated beneficiaries (e.g. your children) can then pass on any unused funds to their own nominated beneficiaries (e.g. their children) and so on.

Let’s look at an example to show how this may work:

Fred dies at age 74 leaving a pension pot worth £200,000. His wife Wendy, age 70, is his nominated beneficiary. Wendy could take the whole of the pension pot as a tax-free lump sum but as she is concerned about her own IHT position, she decides to leave the money invested as this will then be outside of her estate for IHT purposes. She withdraws a tax-free income of £20,000 per annum until she dies at age 78, with the pension pot at that stage being worth £120,000.

Wendy’s daughter had encouraged her a few years before her death to nominate her children (the grandchildren) as her beneficiaries to the pension fund. The grandchildren (age 16 and 18) when Wendy dies, can start to take withdrawals from the pension fund. Although this is taxed as income in their hands, they do not have any other income so can utilise their own personal allowances against this income – making £12,000 per annum withdrawals each and paying no tax as this is covered by their personal allowances. If they do start to work, they can either suspend the withdrawals or continue these and suffer probably only a 20% tax charge.

I hope you can see from the above the power of using pensions as part of some generational tax planning.

As with all financial planning and wealth management, individual advice should be sought before making any decisions. Talk to us if you want a tailored solution to your retirement planning.

By Paul Dell
0203 146 1606