Pension Freedom Rules: Article Two

How best to utilize the new Pension Freedom Rules

Article two focuses on those with either personal pensions or have membership of employer Money Purchase pensions; where the employer and employee make contributions into a pot, and the future pension value will be dependent upon the growth of the monies.

What can you do now?

You have the right to flexibly control your own pension pot. You will have the opportunity to draw cash lump sum(s), to draw and vary income at will, combine both income and lump sum(s), buy an annuity and retain the ability to leave residual pension funds ‘potentially’ tax-free to your chosen beneficiaries.

Annuities

The traditional route of buying an annuity is still available to you and it is likely there will be further innovation and flexibility in this area over the coming months and years. Despite the costs of guarantees and the relatively poor value they tend to represent at present, this solution is likely to appeal to those who want simplicity and certainty. It avoids the need, and potential stress, of having to regularly review the performance and sustainability of their pension pot.

Drawing Lump Sums or a Flexible Income

There are various rules in place here, which have various technical aspects operating in the background, however the key options and points to note are:

  • You can take all of your 25% tax-free lump sum and leave the remainder of the pot invested for future use.
  • You can draw your pension pot in one or more, stand-alone lump sums. Each time you do, 25% of the amount you take is tax-free and the remainder will be taxed at your marginal rate.
  • You can take all of your 25% tax-free lump sum and also draw a taxable income from the remaining 75% of the pot at whatever level you wish, be it as income or lump sums. (This is known as Flexible Drawdown)
  • You can choose to place just a portion of your pension pot into flexible drawdown, in which case the available tax-free cash at that time, will be 25% of the portion of the pot you have placed into flexible drawdown.
  • All the above are available to you at any time from 10 years prior to your State Pension Age, whether you are still working or not.

Below are some of the important issues that may adversely affect you.

  • You will be charged at your marginal rate of Income Tax (which could be as high as 45%) on any monies in excess of the tax free cash allowed
  • If a taxable lump sum takes your income in the year to over £100,000, then you will also lose your personal tax allowance at the rate of £1 for every £2 of income over £100,000. Once your income exceeds £121,200, you would have no personal allowance left. This is an effective tax rate of circa 60% on this portion of your income. You will also be subject to an emergency tax charge on lump sums, which would leave you having to submit a claim for overpaid tax.
  • Any monies taken out of the pension pot and held in the estate may also be subject to a further 40% Inheritance Tax charge on your death.
  • Be wary of investing in assets which are too high or too low risk, being caught by investment scams, and investments that are expensive and not tax efficient.
  • Not considering the impact of your own health or the needs of your spouse or dependant.
  • There may be costs and penalties in encashing or moving your pension and even loss of worthwhile guarantees.
  • Leaving monies invested to draw upon in the future will need good quality ongoing advice, which has cost implications and also raises the question about the need for you to have ongoing mental capacity to continue to make the required decisions each year.
  • The significant long term impact of inflation.
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So if the risks are potentially so great, what are the advantages?

  • You can draw income as constant or variable to suit your changing needs and circumstances
  • You can draw single or multiple lump sums, e.g. for a new car or home improvements.
  • Up to 25% is available tax free, plus you can make prudent use of your personal tax allowances and tax bands.
  • You have no need to commit to the restrictions of annuities but always have the choice of being able to do so.
  • You can preserve unused pension funds to pass on to others potentially free of Inheritance Tax.
  • Prudent use of your pension pot can help assist against the cost of paying for Long Term Care.
  • You can defer drawing benefits from your pension, whilst you live off your other cash and invested assets, thereby reducing the element of your estate that would be subject to Inheritance Tax on your death.

In the next article we will consider what happens to your pension upon death in relation to the new pension freedom rules.

Written by
Karl Lavery