The pension freedom rules allow you a number of ways in which you can access your pension fund. While this improved flexibility is to be welcomed, there are tax and other financial implications that you should be aware of.
What are your options under the pension freedom rules?
1. Cash-in all of your pension fund
You can, if you wish, withdraw all your pension fund in one go. So, if say you have a £100,000 pension fund, then the first 25% or £25,000 of your fund will be tax-free. The remaining £75,000 will be taxed at what is known as your marginal rate of tax.
Your marginal rate is the highest rate of income tax you are currently paying. So, if you are a high-earner, paying income tax at 45%, that becomes your marginal rate. Therefore, your income tax liability on the remaining £75,000 is £33,750.
As a higher-rate tax payer, you would be advised not to take this option and perhaps delay cashing-in until you were on the lower 20% of tax. Even then, the size of the fund means that some of the remaining £75,000 could be taxed at 40% or 45%.
The tax implications of cashing-in all you pension fund and the timing of this can lead to an unnecessary tax liability.
2. Lump sum payments
You can withdraw money from your pension fund in a series of lump sum payments. 25% of every lump withdrawal you make will be tax-free and the remainder of the lump sum will be taxed at your marginal rate.
Technically, this is known as an ‘uncrystallised funds pension lump sum’ (UFPLS). You can take one or more UFPLS payments and these can be regular or irregular payments.
So, if you decide, for example, to take £10,000 out of your pension fund in year one and £20,000 in year two; then in year one the tax-free amount will be £2,500 and year two £5,000.
If you opt to take lump sum payments, you do not have to buy an annuity or put the fund into drawdown (see below). Not all pension providers will allow this option.
3. Life time annuity
You may decide that you want the security of knowing that you have a guaranteed income stream for the rest of your life. If so, you can decide to use some or all of your pension fund to buy an annuity from your pension provider.
An annuity is a series of payments made to you at regular intervals (usually monthly). The amount you receive depends on a number of factors: the size of your pension fund, the age at which you decide to retire, interest rates, lifestyle issues (smokers get enhanced annuities). The annuity can be a fixed amount or increased in line with inflation.
Should you decide to buy an annuity, you can still withdraw a tax-free lump sum of up to 25% of your pension fund. This is called a pension commencement lump sum.
4. Flexi-access drawdown
You can take a 25% tax-free pension commencement lump sum from your pension savings and leave the remaining 75% invested in your fund. You then have the option of withdrawing as much or as little as you want from the fund each year. The amount available for withdrawal will depend on the fund’s investment performance and how much you take out each year.
This option is known as a flexi-access drawdown and you will pay income tax on any amount you do take out.
Which? Magazine has developed a very interesting income drawdown calculator which allows you to run a range of scenarios to see how different decisions can impact on the drawdown income available from your pension fund.
5. Capped drawdown
This option was available before the pension freedom rules were introduced on 6th April 2015. If you were in a capped drawdown scheme before the rule changes then you can continue in this scheme. However, this option has been closed to new applicants since that date.
If you are in a capped drawdown arrangement, you have the option of converting your pension fund into a flexi-access drawdown scheme or continuing to take a capped drawdown pension. Income from capped drawdown payments are taxed at your marginal rate.
6. Short-term annuities
If you have decided to take the flexi-access drawdown option, you can still purchase a short-term annuity with some of the money held in your fund. These annuities can be purchased from an insurance company, have a five–year term with payments made annually.
Which option should you take?
If you decide to cash in all your pension fund, what do you do with the lump sum to generate a retirement income?
If you opt for the flexi-access drawdown and the investments in the fund under perform; or you live longer than you expect; will there be enough left for you to live on?
If you go for an annuity, should it be a joint-life policy or linked to inflation, where can you get the best annuity rates?
There are so many options and decisions that need to be taken over what is a hugely important financial arrangement. Even if you feel confident in taking the decisions needed, you should take up the government’s offer of a free consultation with PensionWise.
There are risks and benefits with each option as well as tax implications so you should seek advice from an independent regulated financial adviser. For guidance on choosing a financial adviser, please follow the link.
