In one fell swoop
Budget proposals allowing people to take out their whole pension have attracted overblown media attention, but this is a real game changer, says Scott Gallacher
Pensions have suffered a relatively poor press for a long time, and a key reason in recent years has been because of the supposed requirement to purchase an annuity. It is worth pointing out at this stage that this is a myth: the requirement was scrapped some years ago with the facility to use ‘drawdown’ throughout your retirement.
That was far from an ideal solution, though. Unless you were lucky enough to have already secured at least £20,000 in guaranteed income, there were strict limits on the amount you could draw out each year. This meant that you could never spend your entire pension fund during your lifetime.
In simple terms, the new rules should allow you to take all your pension as a lump sum should you wish. However, with all the talk of people blowing their pension funds on Lamborghinis, there has been little coverage of the tax treatment of the lump sum.
For most people, 25 per cent of the fund will be the traditional tax-free cash lump (or pension commencement lump sum to use its correct title). Some people may have higher tax-free cash entitlements because of the application of historical rules. The slight sting in the tail is that the remaining fund (i.e. typically 75 per cent) is subject to income
tax on receipt and this rather important fact appears
to have been overlooked by many.
Depending on the size of the pension fund and your other taxable income, this fact creates a potential tax issue for clients who’d like to access their pension – and a significant opportunity for professional advisers to help them.
As an example, next May, Mr Smith is due to retire at 65 with a £100,000 pension pot and a
state pension of £10,000 a year. Not being a fan
of pensions, or wishing to be locked into an annuity, Smith wants to take advantage of the new rules by taking the whole pot as a lump sum.
Unfortunately, despite having been a basic rate taxpayer all his life, doing this will leave him a higher rate taxpayer for that tax year. (See next column.)
It could have been worse. If Smith had, say, a £150,000 fund, his total income for the year would have also had another effect: his ‘earnings’ for the year would have been enough for him to lose his tax-free personal allowance entirely – in effect, another £4,000 in tax.
Hopefully, however, our fictional Mr Smith would have had his financial adviser or accountant on hand, who would have suggested taking his lump sum in three smaller chunks. Taking £25,000 per year over three tax years, he would have remained a basic rate taxpayer in each year, saving a total of £8,627 in tax,
i.e. £15,000 rather than £23,627. (See below.)
It is rare enough that an announcement about pensions causes much interest beyond advisers – let alone the kind of press excitement that greeted this one. It just goes to show that whenever there appears to be a ‘free lunch’, it is wise to check that there aren’t unexpected pitfalls. Your clients may thank you for warning them not to make an expensive mistake.
Scott Gallacher is a director at Rowley Turton
He writes the regular IFA comment in Private Client Adviser