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BLOG: Pension freedoms: just because you can, doesn’t mean you should

Kit Klarenberg
Written By:
Kit Klarenberg
Posted:
Updated:
01/05/2015

It is widely accepted that the continuing changes to pensions legislation make it difficult for the average man in the street to keep up or even engage with the concept of pensions, even if the recent changes are in the interests of consumers.

Contrary to some headlines, it actually hasn’t been a requirement to purchase an annuity since 2006 and a variation of drawdown has been available to all even post age 75 since then. The two options available pre April this year were capped and flexible drawdown.

The former permitted the withdrawal of funds directly from invested pension assets as an income capped annually at a level determined by factors of fund size, age and long term gilt yields. The cap was reset each three years but in the interim, as long as the cap wasn’t breached, the member could enjoy the continued investment of their funds and control of capital. Crucially though, the member had the ability to add to their pension fund at a rate of up to £40,000pa. This contribution limit is called the annual allowance. Those individuals in capped drawdown may continue in this regime provided income levels remain below the capped levels continually set and may also vest any undrawn pensions from the same scheme into capped drawdown post April 2015.

Alternatively they may elect to move to the new flexi-access rules which permit drawdown without limit and importantly without the triennial review costs. The ability to have unfettered access to their pension funds will appeal to many, however it must be remembered that the amount drawn in any one tax year will be taxed at the individuals marginal rate. The larger the withdrawal, the increased likelihood of a higher tax band. The switch to flexi access does have another implication, namely that an individual in flexi-access drawdown who draws an income of even only £1 will trigger a reduction in their annual allowance (the ability to contribute to their pension), to only £10,000pa.

Individuals who had not drawn benefits prior to April 2015 will only be able to use the new flexi-access regime, and if they start to take any income at all, it will also trigger the reduced £10,000 annual allowance.

Flexible drawdown, not to be confused with the new flexi –access rules permitted unlimited drawdown but required the individual to first have guaranteed sources of pension derived income of at least £12,000pa. Those in this regime had no ability to contribute at all going forward and required no reviews. A move to the new flexi access rules would benefit them only in that flexi-access drawers enjoy a £10,000pa annual allowance.

So with the new options now in place, has there been a flood of individuals cashing in their pensions or accelerating the rate at which they withdraw their income? Just because you can doesn’t mean you should, and in reality, there are very good reasons to look at the changes in the round. The large insurers have reported a huge increase in enquiries about flexi access drawdown particularly amongst clients with smaller pension pots, but our own experience has been to the contrary. Clients with more substantial pension savings have focused not so much on the increased ability to access pensions but to a greater degree on the reduction in tax rates applicable to sums remaining within pension pots on the death of the member.

Before April this year, an individual in capped drawdown who died pre age 75 would have left options of either a dependents pension taxable at their marginal rate or a lump sum payment taxed at 55 per cent. New rules permit remaining funds to be distributed either as income or a lump sum free of either income or inheritance tax. Whilst previously any member death post age 75 would have led to benefits the same as the pre April vested drawdown options above, the new rules permit much wider distribution of an income no longer restricted to direct beneficiaries and taxable at the marginal income tax rate of the recipient.

So as a worst case scenario, funds remaining on death could be distributed to high earners with a tax rate of 45 per cent or at the other end of the scale to non-tax payers such as grandchildren at levels up to their annual tax allowance with no tax deduction whatsoever. Both options comfortably beat the combination of member’s income tax and inheritance tax that would apply if monies were drawn as a pension and remained in the member’s estate on death.

This anomaly has resulted in some individuals reducing or even ceasing previous income drawdowns in favour of reducing down their personal estates as part of an overall tax planning exercise.