Pension Nirvana or Pensions Hell?27 March 2014
Today, many thousands of people will, for the first time in their lives, be faced with the temptation of drawing the entire value of their pension funds as a lump sum. David Smith, Wealth Management Director at Bestinvest, investigates who can take advantage of the new rules and, more importantly, whether it is right to give in to this temptation. As is always the case, the devil is in the detail…
The changes announced in the Budget that become effective today impact principally on four pension options; Flexible Drawdown, Capped Drawdown, Triviality and Small Stranded Pension Pots. I will examine each in turn.
Interim Flexible Drawdown
To take advantage of Flexible Drawdown; the ability to draw what you want from your pension when you want, you need a ‘Minimum Income Requirement’ (MIR) of £12,000 with effect from today (£20,000 previously). However, only certain types of income count towards the MIR including:
· Social Security Pensions paid by the state.
· Lifetime annuities paid from registered pension schemes.
· Scheme pensions paid from certain registered pension schemes.
· Payments under the Financial Assistance Scheme that are payable until death.
· Payments from overseas pension schemes or social security pensions that are substantially similar in characteristics to any of the first three options above.
Drawdown income from pensions and other non-pension investment income do not count. Furthermore, only income that will physically be received in the tax year can be counted, so if you bought an annuity midway through the next tax year for £12,000 and it was paid monthly, only £6,000 would count against the MIR for that year.
In order to apply for flexible drawdown no contributions to a pension must have been made in the same tax year, nor must any benefits have been accrued in a final salary scheme. If you lie about such accrual – intentionally or otherwise, the flexible drawdown declaration you will have signed will be deemed invalid and you will typically face penal tax charges. Many will have paid contributions or have accrual in the current tax year and therefore must wait until 6 April before using Flexible Drawdown.
The lump sum payable is not completely tax free; only 25 per cent is, the other 75% is taxable. Tax will typically be deducted by your pension provider at the basic rate of 20 per cent using Pay As You Earn (PAYE). However, the actual amount of tax that you end up paying will depend upon your total income for the tax year; higher or additional rate taxpayers may need to pay more tax. If you retire on the 1st March 2014 you would therefore normally be better drawing a lump sum post 6 April 2015 so that your employed earnings and drawdown payment do not get caught in the same tax year leading to what could be a penal and potentially avoidable tax charge.
Be careful that you are not giving-up a valuable ‘hidden’ benefit incorporated within an existing pension plan by using Flexible Drawdown. Many older pensions, particularly retirement annuity plans, incorporate Guaranteed Annuity Rates and these rates may be so high (11% is not uncommon) that drawing an annuity would prove more beneficial than taking a lump sum. Also, watch out for transfer penalties - you may be over age 60 but if your pension has a Selected Retirement Age (SRA) of 65+ it could be subject to penal charges on early vesting. In fact the charges could be high enough to warrant deferring the decision to draw until after SRA.
Individuals who enter into Flexible Drawdown also need to consider the impact on their pension fund in the event of Bankruptcy. Under current legislation any pension income in payment can be used by the trustee in bankruptcy to meet to partially fund creditors and, whilst you may not be receiving an income from the pension by going into flexible drawdown, the trustee may be able to attack your entire pension fund. Legal advice would need to be sought in this matter.
A similar consideration needs to be taken into account for funding long term care costs, as Local Authorities may include the full value of the pension fund for those individuals in flexible drawdown rather than the actual pension income they receive.
Finally, shop around for a competitive Flexible Drawdown Provider. Charges can be complicated and difficult to compare. The size of your fund and how quickly you wish to completely exhaust your pension fund will typically dictate which Flexible Drawdown Plan will best suit you.
From today, when a client goes into drawdown for the first time, or has one of their ‘scheduled’ triennial or annual reviews, the calculation of their maximum drawdown income will be based on 150% rather than 120% of the Government Actuary’s Department equivalent annuity.
Based upon current GAD rates a 65-year will see the income rise from his £100,000 pension fund from £7,080 to £8,850. This represents an immediate 25% increase in the maximum income available.
The new ‘Triviality’ rules are also available with effect from today, and the good news is that anyone in a position to take advantage of this facility should be able to do so via their existing pension provider, cost free – there is no requirement to transfer to a Drawdown contract. You will simply need to complete a simple application with your existing pension provider, which will incorporate a disclaimer confirming that you do not have other pension arrangements that are cumulatively worth more than £30k. Some Scheme Administrators may ask for a valuation of your other pension plans.
· Be careful you don’t have any pensions that you have forgotten about or that are worth more than you think; a Defined Benefit Pension worth more than £1500 per annum would exceed the £30,000 triviality rule (you multiply the pension from a defined benefit pension by 20 to get an equivalent value). If you say your pensions are worth less than £30k and it transpires that they are worth more, your payment will be treated as an ‘unauthorised payment’ and be subject to a 55% tax charge
· You must take all the savings in all of your pension pots within the same pension scheme as a lump sum and have your pension savings in all your pension schemes valued on the same date, which must be no more than three months before you take your first trivial commutation lump sum.
· If you are taking a trivial lump sum from more than one of your pension schemes you must take all the trivial lump sums within 12 months of the first lump sum payment.
· Only 25 per cent of the lump sum is tax free, the other 25% is taxable. The Pensions administrator will deduct any tax due at the basic rate of 20 per cent using Pay As You Earn (PAYE). The actual amount of tax that you end up paying depends on your total income for the tax year; higher or additional rate taxpayer may need to pay more tax, while non-taxpayers will receive a refund. If you retire on the 1st March 2015 you would therefore be better drawing benefits using triviality rules on 6 April 2015 so that your employed earnings and triviality payment did not get caught in the same tax year potentially leading to a penal and wholly unavoidable tax charge.
· It’s possible that not all pension providers and contracts will have systems in place to offer a lump sum payment. Under such circumstances, monies would have to be transferred to a plan that does allow the facility which could incur costs.
· Be careful that you are not giving-up a valuable benefit! Many older pensions, particularly retirement annuity plans, incorporate Guaranteed Annuity Rates and these rates may be so high (11% is not uncommon) that drawing an annuity would prove more beneficial than taking a lump sum.
· Watch out for transfer penalties; you may be over age 60 but if your pension has a Selected Retirement Age (SRA) of 65 it could be subject to penal charges on early vesting. Indeed the charges could be high enough to warrant deferring the decision to draw until after SRA
· Pensions can be taken on the grounds of triviality only from age 60, not age 55, which is a common misconception, and you need to be with a Pension Administrator that allows this facility.
Small Stranded Pension Pots
Under the new rules clients aged 60 or over to take all of the funds in a specific pension arrangement if the value of that arrangement is less than £2,000. Under current rules only two small lump sums may be paid to any individual, regardless of how many individual pension arrangements they hold that qualify.
From 27 March 2014 the £2,000 limit will increase to £10,000 and the maximum number of small pot lump sums that a client can receive will increase from two to three. The tax position is the same as described for Triviality.
The small lump sum rule can be used in addition to the Triviality rule. Therefore someone with three separate pension arrangements each worth less than £10,000, where their other pension benefits are worth less than £30,000, will be able to take small lump sums from each of the three sub-£10,000 pensions and then apply for trivial commutation. It is therefore potentially possible to access £60,000 in total by cleverly combining Triviality and stranded pension pot rules.
Whilst the options that have become available today will, in their own right, change the face of pensions forever, the amendments that the Government are proposing next year are even more wide-ranging. At last we will be treated as grown-ups when we stop work. With one sweep the Chancellor will sweep away layer upon layer of complex pension rules built up from the first part of the last century which truly was a different world. In the new world it will be "here's your fund, do with it what you like". It's got to last the rest of your life though – so don’t give in to temptation too readily or you may end-up in pensions hell…
To discuss the issues raised above in more detail, please contact David Smith on David.firstname.lastname@example.org or 0191 269 9970 / 07778 066 367
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