The broad strokes

The hugely anticipated and well documented pension reforms came into effect yesterday (6 April). No longer will savers be limited in how they can access their defined contribution pension savings. No longer will they need to fear the 55 per cent special death tax when pensions are inherited. It seems an appropriate time then, to recap the broad changes and clarify the new position of pension savers.

The principal changes

Previously drawdown was either capped by reference to notional annuity rates or could be flexible provided that a minimum income requirement was met. These restrictions fall away completely and all or any part of the pot can be taken freely at any time from age 55.

There are now two drawdown options:

• under flexi access drawdown, up to 25 per cent of the total pot can be taken as a single tax free cash lump sum, and then the balance drawn over time as income taxed at marginal rates;

• under the snappily named 'uncrystallised pension fund lump sum' (UPFLS) approach, 25 per cent of any payment from the pot, of whatever amount, will be treated as tax free cash and the balance as income taxed at the individual's marginal tax rate. There are questions as to how this interrelates with PAYE Codes.

Undrawn funds left in the pot on the individual's death are not part of the estate or subject to inheritance tax (IHT). Previously the funds could be paid out tax free if the member was under 75 at the date of death and not in drawdown. Otherwise a 55 per cent special tax charge would be applied to the funds (with exceptions only for a limited class of beneficiaries). The 55 per cent death charge is now abolished.

There will be no tax payable if the individual dies before age 75 and on a death after age 75, funds can be taken as income taxed at the recipient's marginal tax rate. The recipients can include all dependants but also persons nominated by the individual or by the trustees of the plan.

Please note that all the changes are extremely complex and technical in nature, and this is a very brief summary of the position.

Planning considerations and opportunities

Pensions as IHT shelter

Investors have previously been advised not to leave pension funds undrawn indefinitely, because of the potential charge to tax at 55 per cent rather than IHT at 40 per cent.

Now however, where an individual holds investments both in pensions and in other arrangements, (including ISAs and non-tax sheltered accounts) it may be better to spend money outside the pension first, in order to reduce the possible IHT bill. Depending on age at death, pension assets may be tax free or potentially taxed at rates lower than 40 per cent.

Using pensions to pass down wealth through generations

Pension funds can now, on the saver's death, be passed on to relatives such as adult children and grandchildren, even if they are not dependent, without IHT or a 55 per cent tax charge. They will only be taxed at the recipient's marginal tax rates.

So funds could be paid to grandchildren to cover all or part of school fees, university fees and income top ups in the early years of their careers, using up their personal allowance and with tax payable (if at all) only at the 20 per cent basic rate.

Adult children could take income from a deceased parent's pension fund to allow them to make higher contributions to their own pension schemes, and claim more tax relief.

Lifetime allowance

An individual's pension pot is tested against the lifetime allowance at the time it is put into drawdown or at age 75 if it is not in drawdown. The impact of the lifetime allowance charge can be mitigated by going into drawdown just before the pot breaches the lifetime allowance limit; following the reforms this will no longer cause the 55 per cent death charge to apply.

After age 75, there is no further test against lifetime allowance, even if the fund is well invested and grows materially. The pot can be applied after the individual's death to make payments to beneficiaries nominated by the individual, and on the death of the initial recipients to their nominees, potentially indefinitely, without any further lifetime allowance charge.

Note that taking funds as flexi-access drawdown or UFPLS will have different impacts in relation to the lifetime allowance test, which makes the decision of how to draw funds very complex.

Flexibility to adapt to income needs

Pensioners will be able to adapt their pension drawdown rate to their circumstances. This could be used pay off debts, or could perhaps involve drawing more heavily in the early years of retirement while they are more active. Or it could be a case of increasing income before a defined benefit pension or the state pension becomes payable.

Limits and caveats

For high net worth individuals, the lifetime allowance, currently £1.25m but reducing to £1m from April 2016, limits the amount of assets which could be sheltered from IHT, as does the low annual allowance which limits how much can be put aside annually. However pensions can still be a useful part of a more complex strategy within those limits.

While the strategies mentioned above flow from the legislation and would not be characterised as aggressive tax avoidance, anti-avoidance limits could be placed on them in future years if there is negative publicity.

Finally, savers should note that they should not rush to take funds out of their pensions pots just because it is now possible - the pension scheme is still an effective tax wrapper, and the industry is still adjusting to the changes and coming up with new strategies to make best use of the new flexibility.

Jane Wolstenholme is a partner in the immigration, pensions and employment team at Charles Russell Speechlys

 

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