Pension Flexibility – Basics
There has been a great deal of publicity about recent changes in the law relating to pensions and their uses. The changes are comprehensive and change the tax position significantly and also the uses which can be made of pension funds.
With continuing low historical interest rate yields, annuity rates have remained low for years, leaving pension fund owners in difficulties because their expected annuities when they took out the policies are much greater than the actual annuities being quoted now. This has been compounded by a long period of lacklustre returns on the stock market.
Accordingly, the Government decided to introduce flexibility in the pension market and introduced a services of changes designed to do this. The changes mainly apply when a person ‘becomes entitled’ to a pension on or after 6 April 2015 or a lump-sum payment is made after that date. Using Self-Investeded Pension Plans, the owner of a pension fund now has a very considerable degree of control over the investments that make up their pension pot. One downside of this has been a rise in pension fraud, in which unscrupulous ‘financial advisers’ persuade the owners of pension pots to transfer them to the fraudsters n the promose better rates of return.
The Government had already announced changes introduced from 27 March 2014 that increased the amount of pension fund that can be treated as trivial and taken as a lump sum, from £18,000 to £30,000, where the total of all pension schemes held is less than that sum.
The changes do not apply to pensions which have been used to buy an annuity. Where an annuity has been purchased with the fund, the remaining value of the fund belongs to the provider of the annuity.
There are a variety of detailed provisions designed to prevent the use of pensions to prevent use of the arrangements for tax avoidance. What follows, though relevant for most pension pot owners, will not apply in every instance and professional advice should always be taken.
There are different rules which apply to drawdown pension funds created before 6 April 2015 and those created afterwards, which are termed ‘flexi-access’ drawdown funds. Where a fund has been created before this but not accessed, an uncrystallised funds pension lump sum’ (UFPLS) of 25 per cent may normally be taken. Taking a UFPLS will lead to the annual allowance for contributions being set at £10,000 for money-purchase schemes.
Changes in taking funds
The new system allows the whole of a fund to be taken by way of ‘draw down’, with 25 per cent of the pension pot able to be taken free of tax.
It is important to understand that if (say) £10,000 is required from a pension pot of (say) £200,000, there is no need to take it all as part of the 25 per cent tax free lump sum. If, for example, you could have additional taxable income of £6,000 without paying tax, you could opt to take £4,000 as part of the tax-free lump sum and the rest as taxable income. It will thus be possible for many pensioners to use their pension funds tax-efficiently. Once 25 per cent of the fund has been taken as tax-free cash, then any sum taken will be taxable. However, 25 per cent of the income earned in the fund during the period in which it is being drawn down can also normally be taken tax free.
The rules also allow some changes to the benefits that can be offered by insurers to pension fund holders.
For example, the current 10-year cap on a ‘guarantee period’ (where the pension is guaranteed for a period of years if the pensioner dies during the guarantee period) is to be removed.
Trivial and ‘small pot’ pension will be able to be taken at 55 (or earlier, where there is ill-health), not 60 as at present.
Changes relating to death
Pension savings in drawdown or in defined benefits schemes can be passed on on death to the beneficiaries of the fund owner without being taxed from 6 April 2015.
The transfer will be tax free if they die before age 75. Income taken from the fund will be taxed at the recipient’s marginal rate of Income Tax (IT). However, to qualify for a tax-free withdrawal, the lump-sum must be paid within two years of notifying the scheme administrator of the death.
Where the owner of the fund is over 75 on death, the beneficiaries can either continue to take the drawdown, in which case the income will be taxed at their marginal rate of IT, or take the entire fund, which will be taxed at 45 per cent. This is only marginally above the current rate of Inheritance Tax.
Currently, where the owner of a pension is 75 or more, or the pension is in drawdown, a 55 per cent tax rate applies. An untouched pension pot of less than £1.25 million will currently be passed on tax free.
Further details can be found on the HMRC leaflet ‘Pension Flexibility 2016’.
For more details in the Inheritance Tax implications, see the HM Treasury announcement of 29 September 2014.
The lifetime allowance for pension contributions is now £1 milion.
There are still older pension policies with guaranteed annuity rates (GARs), some of which provide pensions annuities greatly in excess of current market rates.
In addition, some policies have guaranteed rates of return build into the funds.
It is extremely important to take advice when considering what is best to do with your pension funds.