Cutting through the confusion: pension income options explained

31st March 2015

img

With just a few days to go until the pension freedoms start on April 6, many investors are still unclear about exactly how they can access their retirement savings. Hargreaves Lansdown, the adviser, provides this guide to two key ways of drawing an income….

Many pension providers and schemes will only be able to offer very limited options. This means that if investors do want to exercise their freedoms, they need to plan ahead. Critically, they should explore which of the retirement income options will best suit their needs. If necessary, they should move their retirement savings to a pension provider which offers them the right options.

Tom McPhail, Head of Pensions Research: “Selecting the right retirement income arrangement could save you thousands of pounds in tax; it is also vital that investors can get access to the best possible investment options. Don’t just assume that your existing pension provider has all the right answers until you have shopped around. Even one modest income withdrawal from your pension could have significant long term financial planning consequences.”

Key differences between Flexi-access drawdown and Uncrystallised Funds Pension Lump Sum (UFPLS):

UFPLS example

George has a £100,000 pension pot; he is 57 and earns £30,000 a year. He wants to withdraw a one-off lump sum to buy a new kitchen. He uses the UFPLS rules to withdraw £10,000. The remaining £90,000 of the pension pot remains untouched and continues to grow free from further tax.

Of the withdrawal, £2,500 is tax free and the balance of £7,500 is taxed as income. He receives a net payment of £8,500. The remaining £90,000 is still invested in his SIPP.

Unlike drawdown, UFPLS typically only pays out a small slice of the total tax free lump sum entitlement. This means that in the long run, using UFPLS could deliver a higher tax free cash payment as the pension fund remains invested and grows.

For example:

David has a £100,000 pension pot. If he moves it all into drawdown now, then he’d be able to take £25,000 out tax free.

However if he doesn’t need all his cash now, he could use the UFPLS rules to take £25,000 out now, of which £6,250 (25%) would be tax free and the balance would be taxed as income. This would leave £75,000 invested in ‘pre-retirement’ funds.

Suppose the £75,000 grew to £100,000 over the next 10 years, and he then moved the whole lot into drawdown. He could then take 25% of this remaining pot tax free, giving him a further £25,000; his total tax free withdrawals would have been £31,250.

Drawbacks

As soon as an investor makes a withdrawal using UFPLS, they are deemed to have used the pension freedoms. This means they are then restricted to the £10,000 Money Purchase Annual Allowance and are unable to use the Carry Forward rules.

For most people most of the time this will not be a problem, however occasionally such as following receipt of an inheritance, investors may want to make a substantial one-off payment into their pension fund. For this reason they should make absolutely sure that they won’t be compromised by this restriction, before using this freedom.

Every time an investor uses UFPLS, they are going to have to run through the ‘second line of defence’ compliance checks, which could get a little tedious if they’re planning on taking monthly income. By contrast, with drawdown they can move money into drawdown, set up a regular income instruction and go get on with their lives.

Drawdown example

Steve is 66 he has £100,000 in a SIPP. He uses £50,000 to buy himself an enhanced annuity paying £3,200 a year, having shopped around to find the best possible deal. He invests the balance of £50,000 in his drawdown and takes the tax free lump of £12,500 and an income of £100 a month.

With a drawdown an investor can take just the tax free sum and defer drawing any income if they wish. As long as they just take the tax free sum, they are deemed by HMRC not to have exercised the pension freedoms yet and so will still have an annual allowance of up to £40,000 and will be able to use the Carry Forward facility.

Drawbacks

If taking 100% of tax free cash up front, this will result in a lower overall tax free payment than if using UFPLS. Setting up a Drawdown may well feel like a more substantial transaction and may involve transferring funds to another pension provider. For this reason, UFPLS may be more accessible for some investors.

How to get the best of both worlds: Phased drawdown

Canny investors can combine the benefits of both schemes by phasing their pension savings across into a drawdown plan:

Phased drawdown example

Danny is 56 and has £200,000 in his pension pot. He wants to take some money out, doesn’t want to trigger the Money Purchase Annual Allowance but also doesn’t want to take all his tax free lump sum up front.

He transfers £20,000 into a drawdown plan. He takes the 25% tax free sum of £5,000 and leaves the remaining £15,000 in the drawdown plan without taking any income.

2 years later, he transfers a further £20,000 across to the drawdown, takes another £5,000 in tax free cash and again leaves the balance of £15,000 in the drawdown plan together with the original £15,000 from 2 years ago.

Assuming he enjoyed 4% net investment growth over the 2 years, he now has £174,688 in his pre-drawdown pot and £31,224 in his drawdown pot. He has also received £10,000 tax free.

He can keep doing this until he has transferred all his pre-retirement money across into drawdown.

At the same time he can continue to use the full annual allowance of £40,000 and carry forward if he wishes.

Key questions investors should ask

What options do they offer?

Some providers are offering drawdown, others are offering Uncrystallised Funds Pension Lump Sum (UFPLS); some are only offering UFPLS on an all or nothing basis, so if you want to use it you’ll have to take all your pension fund out as cash in one go. The first thing an investor should do is to ask their existing pension provider exactly what options they are able to offer.

How will tax deductions be calculated?

The tax treatment of drawdown and UFPLS is similar but the timing of the tax payment is different. Investors should make sure that their pension provider knows what they are doing when it comes to the tax treatment of their pension fund withdrawals. UFLPS generally suits those who do not need all their tax free cash up front and by spreading it out, as part of their income withdrawals, reduce the amount of tax paid.

What investment support will they offer?

Many investors using drawdown or UFPLS will need help and guidance to ensure that their investment choices are consistent with taking an income, as well as with the level of income they are withdrawing. Without this support there is a risk that they may experience unexpected and unwanted surprises. This is particularly relevant where someone has been auto-enrolled into a default fund and is now looking to use UFPLS to take an income.

Hargreaves Lansdown offers both UFPLS and Drawdown. We make no additional administration charges for income payments under either scheme.

Drawdown versus Uncrystallised Funds Pension Lump Sum (UFPLS)

Drawdown

UFPLS

Eligibility Open to any investor over age 55 who wants to keep pension fund invested Open to any investor over age 55 who wants to keep pension fund invested
Suitable for those who want to: 1.     Take all the tax free cash up front2.     Take tax free cash and defer income3.     Take any kind of frequent or regular income after tax free cash paid

4.     Retain the £40,000 annual allowance and carry forward capability (for as long as you’ve only taken the 25% tax free lump sum)

1.     Take one off ad-hoc payments before retirement2.     Spread taking their tax free cash over a number of years, rather than taking out up front in one go3.     Minimise tax on the regular or periodic withdrawals from their pension

4.     Maximise the overall amount of tax free cash paid out of the pension pot

 

Will part of the payment be tax free? Yes – usually up to 25% of the fund is paid as a tax-free lump sum.No – Once all the tax free cash is taken, the remaining 75% is taxable as income Yes – every withdrawal will consist in part of tax free cash, usually 25% of the amount taken, with the remaining 75% taxable
Does an income have to be taken straight away? No – after taking the tax-free cash the remaining drawdown funds continue to be invested and income deferred. There is no minimum or maximum withdrawal limit and a decision can be taken each year. Alternatively regular withdrawals can be arranged. Each withdrawal will consist of 25% tax free cash and the rest taxable. As the remaining fund grows, the amount of tax free cash will also grow.
What about tax? When you decide to take income from drawdown funds, each payment will be subject to Pay As You Earn (PAYE) income tax. 75% of each withdrawal will be subject to Pay As You Earn (PAYE) income tax.
What are the tax deductions? Hargreaves Lansdown, like all pension providers, will deduct tax, where applicable, before any withdrawal is paid out. Withdrawals will be added to income in that tax year and subject to any further income tax. Large withdrawals could result in being pushed into a higher tax bracket.For investors first taking income from drawdown or via an UFPLS, it is likely emergency tax will be deducted, unless we are supplied with a current and original P45. Investors paying too much tax will be able to reclaim this from HMRC directly. The tax paid will depend on personal circumstances, and tax rules can change in the future. 

Leave a Reply

Your email address will not be published. Required fields are marked *