Pension paradox

The subject of pensions, let's face it, has never been a thrilling one. Most people tend to glaze over at the mere mention. But suddenly, that's all changed. Pensions are in every newspaper, every consumer programme and uppermost in the minds of millions. The reason, of course, is the new pension freedoms initiative.

This time, it's not all government spin. Of course there is some of that involved (compulsory annuitisation actually disappeared some years ago, for example) but the decision to '…trust people with their own money', as George Osborne puts it, truly is revolutionary.

The revolution arrived on 6 April. Everyone expects to see a mass exodus from pensions with many who are old enough (55+) 'cashing-in' their pensions straight away. Perhaps some really will use it, as pensions minister Steve Webb suggested, to buy a Lamborghini.

In among the excitement, there are some pitfalls. As I covered in a previous column, normally 75 per cent of the pension money taken is subject to income tax. Those people who take large amounts in one go could therefore find that their normal 20 per cent tax rate is suddenly 40 per cent, or even 45 per cent in the year they take the money.

However for many of the clients we look after (generally older, wealthier and with a potential inheritance tax liability) the paradox of the new pension freedoms is that rather than using the flexibility to withdraw their pension fund, they should actually consider never drawing them at all.

Many of our clients would be best leaving their pension funds untouched, or even better, making additional contributions; even if this means them having to spend their other non-pension assets to fund their retirement.

This might seem bizarre given the predicted flood of people clambering to exit pension schemes, but the logic behind this surprising idea is that the changes aren't just about access to pensions, but also about what happens on death after retirement.

Under the old rules, it could take twenty years to get your money back and so there was an argument for drawing moneys as soon as possible, in order to have the maximum chance of getting your money back. The alternative (where you started drawing down on a still-invested fund) could give an ongoing but restricted pension to a surviving spouse, but otherwise a 55 per cent tax charge.

Now though, on the death of a policyholder before age 75, the entire pension fund can be paid out tax free, subject to any lifetime allowance limit. After age 75, the pension fund is effectively transferred into a new pension for one's spouse or children (or other beneficiaries) for them to use as their own.

Like any pension, any withdrawals are subject to their own normal income tax rates but importantly, without any inheritance tax.

For example, our client 'Mr Smith' is 65 and has a house worth £325,000 (conveniently the inheritance tax nil rate band), ISAs of £300,000, a state pension of £10,000 a year and a pension fund of £300,000. If he withdrew his pension fund at day one, he'd be facing an income tax bill of around £92,000 and a potential inheritance tax liability of about £203,000. If he died shortly after taking his pension, he'd leave his family with just £630,000.

But if he had left his pension fund untouched and spent down his ISA fund instead, his family would receive £805,000 after inheritance tax; a £175,000 tax saving. Over time, as the ISA withdrawals reduced the size of the estate and the pension fund continued to grow, arguably the tax saving could be higher and higher.

The paradox then is that at the very point such attractive freedoms are offered for the first time, the advantages of leaving the money have also grown much stronger. If you, or your clients, are expecting to take advantage of the new pension freedoms, it would be a good idea to think through these aspects beforehand. 

Scott Gallacher is a director at Rowley Turton

He writes the regular IFA comment in Private Client Adviser