All change for pensions
With April seeing the latest pension reforms coming into effect, now is the time to review your retirement plans.
The pensions industry is in the throes of a revolution. A wave of reforms taking effect in April will bring more flexibility to everything, from the way benefits are taken to what happens on death. They will affect everyone with a defined contribution pension, and everyone should seize the opportunity to review their retirement plans to make the best of the changes.
These reforms apply only to those with defined contributions schemes, where a set amount is paid into the fund and the benefits depend on the amount accumulated. The reforms touch all the key areas of pensions: the tax-free lump sum; how income can be taken from the fund on retirement; the so-called ‘death tax’ on pensions left in an estate; and the level of contributions that can be made after some funds have been drawn from the pension. The impact of all four will be far-reaching.
Ian Price, divisional director for pensions at St. James’s Place, says: ‘These changes mean that, from April, everyone with a defined contribution pension will have far more choice about
how they take their pension benefits. But the decisions about how to use these freedoms are not easy ones and it is essential that everyone takes appropriate advice to ensure they opt for the right solution for them.’ Most pension funds allow their members to take a tax-free lump sum of up to 25% from their fund.
The first reform means that, from April, it will be possible to withdraw amounts directly from the fund without having to enter drawdown or buy an annuity, with a quarter of each such payment being tax-free. For example, someone with a £100,000 pension pot could choose to take £25,000 at once, with all subsequent withdrawals taxed as income; or they could take 10 payments of £10,000 each, with £2,500 of this paid free of tax.
That could be an attractive option for those who do not need a large sum of cash. Not only does it allow some tax planning, it also means that the funds remain invested in the pension for longer, potentially earning greater returns. That brings us to the second reform: the scrapping of restrictions on using ‘drawdown’ – taking a regular income from your pension while leaving it invested. The current system has financial constraints regarding the maximum amount that can be drawn from pension funds.
From April, there will be complete freedom over how to take benefits, from taking the whole fund at once (dubbed the ‘Lamborghini option’ after pensions minister Steve Webb said individuals were free to blow their retirement savings on one if they wished), to taking lump sums as required, or drawing a regular monthly income.
But the objective of a pension fund should be to provide regular income in retirement; so withdrawing everything is likely to be sensible only if the funds are small, or in exceptional circumstances.
There are tax implications to be considered: any amounts withdrawn over the tax-free lump sum described above will be taxed at the marginal rate, so a basic rate taxpayer will pay 20% tax; but if the pension withdrawal pushes income to higher levels, it will be taxed at 40% or 45% as appropriate.
“Everyone will have far more choice about how they take their pension benefits”
But the new rules will mean everyone over the age of 55 has the opportunity to choose how and when they take their pension benefits. While some may still opt for the certainty of a regular income, whether through the purchase of an annuity or through drawdown, others will welcome the freedom to dip into it occasionally.
The third major change is to abolish the 55% tax, which is currently charged on lump sum death benefits from pension funds being used to provide benefits like income drawdown. From April, pension funds left by anyone dying before the age of 75 will be free of tax if they are taken as a lump sum, or the beneficiaries draw an income from it. They will only be subject to tax if dependants of the deceased choose to buy an annuity; otherwise there will be no Income Tax to pay.
If the death occurs after the age of 75, there are three options, all with different tax implications. The beneficiaries can take the whole fund as a lump sum, which will be subject to a 45% tax charge. They can take a regular income through drawdown; or, if they were dependants of the deceased, they can use it to buy an annuity. In the latter two cases, the income will be taxed at the beneficiaries’ marginal tax rate. Lastly, they can take lump sum income payments through drawdown as required, which again will be subject to tax at marginal tax rates. Assets in pension funds at death will usually remain outside the Inheritance Tax system.
Personal pension contributions on which you can claim tax relief are restricted to 100% of earnings, up to a maximum of £40,000 a year, and this will not change after April. But a new lower maximum of £10,000 a year will apply once withdrawals above the tax-free lump sum are taken. The reduction in the annual allowance to £10,000 won’t apply if you enter capped drawdown before 6 April 2015 (and stay within the income limits) – but it also won’t apply if you buy a lifetime annuity.
The government will allow those in private sector defined benefit schemes – such as final salary schemes – to switch into a defined contribution scheme. That could mean you lose the very valuable benefits that many of these schemes have; so it is essential that anyone considering such a step takes financial advice.
Indeed, in recognising that the new system is complicated, the government is arranging free guidance which will be available from organisations such as The Pensions Advisory Service. While ‘guidance’ will explain what people can do, most people want to know what they should do; so advice remains essential. Among the many issues that will need to be considered is the balance between pension and ISA savings. Payments into the latter do not receive tax relief upfront, while pension contributions have tax relief at the highest marginal rate. In addition, ISA proceeds can be taken tax-free, while pension income is taxable. The reforms mean it is essential to seek advice to find the best balance between the two.
The reforms may not yet be complete: there is speculation that the quid pro quo for giving pensioners greater freedom in how they use their money will be a restriction of the tax relief on pension contributions; although there has so far been no official statement on this. There are already indications that pension savers plan to make full use of the new freedoms. A survey by the National Association of Pension Funds found that a quarter of people intended to take all their pension in cash when the regulations are changed. While many of these had other income they could use to fund their retirement, one in five of those planned to do this regardless of whether they had funds elsewhere. On the positive side, however, more than half of those questioned – 58% – would prefer to use their fund to generate a regular income. That will remain the priority for many investors, regardless of the new freedoms.
The changes to the inheritance rules for pensions have attracted particular attention, with some commentators suggesting that the scrapping of the death tax gives significant opportunities for estate planning. Ian Price cautions against getting too excited by the changes. He points out that for the vast majority of people the key objective will be to ensure that their pension fund provides enough income for them throughout their retirement, rather than to view it as an Inheritance Tax saving mechanism.
A 65-year-old man, for example, could expect to live for a further 22 years, and a woman 24 years – that means income from a pension fund could have to last for a considerable period1. Average pension sizes also remain worryingly low: the mean size of a pension fund used to buy an annuity was just £38,600 in 2014, according to the Association of British Insurers. While that average is after any lump sums have been taken, and excludes larger funds where the pensioner opted for drawdown, it does highlight the low level of pension savings in the UK – something that these reforms, and other initiatives such as auto enrolment, are intended to address.
The levels and bases of taxation and reliefs from taxation can change at any time. The value of any tax relief is generally dependant on individual circumstances.