Pensions in Vogue
It used to be a universal truth that, if you were at a dinner party, and you dared to disclose that you worked in pensions, people instantly made their excuses and left the table. Even the more polite guests would visibly deflate at the mere mention of your profession. In all honesty, the majority of people who worked in pensions weren’t even invited to dinner parties! But that was until last April, when suddenly pensions became rather more a la mode; they are the hot topic of the year, and suddenly people cannot get enough of talking about their pension pots.
Let’s remind ourselves of Mr. Osborne’s exact words: “We will legislate to remove all remaining tax restrictions on how pensioners have access to their pension pots. Pensioners will have complete freedom to draw down as much or as little of their pension pot as they want, anytime they want. No caps. No drawdown limits. Let me be clear. No one will have to buy an annuity.” This has subsequently become known as ‘Pensions Freedom.’
Just when we thought it couldn’t get any better for the world of pensions, on the 3rd December in his Autumn Statement, Mr. Osborne threw us an even more acute curve ball; he announced that the 55% Death Tax in pensions would be scrapped. Whilst less well publicised, this later change is even more dramatic if we look at the bigger implications. These two significant changes will revolutionise how the UK will finance their retirement:
Firstly let’s focus on the ‘pension freedom’ aspect. If you are a pensioner, you can take your entire pension in one go. George Osborne, the emancipator of the pension pot, has given retirees the freedom to choose what they do with their pensions. So whether you want to leave your pension to your loved ones, or even take the whole of your pension in a lump sum, the choice is now yours.
Traditionally, at retirement, a pension offers 25% of the savings as a tax free lump sum, and the remainder is used to purchase an income; often through buying an annuity. Annuity rates have fallen to all-time lows and retirement incomes have come tumbling down with them. This has led to more and more people, who have sought advice, using a route called ‘drawdown’. This is similar to the traditional method, in that you can take your tax free lump sum, but you leave the rest of the money in a pension and draw an income from the investment. This income can be varied to give you flexibility.
However 2014’s Budget, and the subsequent announcements from Mr. Osborne, will shake this system up. The changes proposed will massively increase the flexibility of drawdown. You can take as much or as little of your pension out, all in one go, should you wish to pay off the mortgage, buy a rental property or purchase the proverbial Lamborghini! But before you get too excited, please read on, as I might be about the stop you in your tracks.
The downside of taking all of your pension in one go is that you will pay Income Tax on this money at your marginal rate. What I mean by, is that if you are taking out a lump sum of £200,000, as an example, you will pay tax at the following rate on the different slices:
|£10,500 - £42,285||
|£42,285 - £100,000||
|£100,000 - £121,000||
|£121,000 - £150,000||
|£150,000 - £200,000||
So to take out £200,000, over and above the tax free element as a lump sum, will mean that you only actually pocket £123,737 of your money. This is an effective tax rate of 38%. Not sounding quite so attractive now is it! Add to that the fact that the money is now in a taxed environment rather than the tax free shelter provided by the pension, and it’s starting to make even less sense. The alternative of drawing the money out gradually, by taking an income of £34,500 per annum, means you could pay an effective tax rate of 15%, or, even better, at £10,500 and paying no tax at all.
So what about the long term prospects of what happens to the money upon your death? This brings us nicely onto the removal of the 55% tax charge. Without this tax, the pension has become a really quite powerful estate planning tool. Money left in your pension will pass to your beneficiaries completely free of Inheritance Tax if you die before the age of 75. If you die after the age of 75, it will be taxed at the recipient’s marginal rate. This could of course be the grandchildren, who may be non-taxpayers. This could pay for their education, or the family holiday. Who’d have thought your teenage children could be paying for their parents to go on holiday to save tax!
Another consideration, is that not only is the pension growing in an environment that is protected from tax, potentially it could also be protected from long term care fees too. Only time will tell whether this is the case, but this has certainly presented some interesting planning opportunities that could significantly increase your family’s wealth. We might see some examples where people in their 70’s and 80’s are making pension contributions as part of their estate planning. It will probably make sense to generate as much income from your other assets first, to preserve the pension as long as possible to maximise what you leave behind to your loved ones.
Whilst it is not my place to tell you how to spend your hard earned cash, I would recommend some careful and strategic planning to maximise your pension pot, minimise your tax, and ensure you do not run out of money during your lifetime. We use tools like Lifetime Cash Flow Forecasts to model these scenarios for our clients to ensure they maximise their money whilst living out the retirement of their dreams. Retirement is about enjoying the proceeds of your success ticking off the bucket list, but if you can also leave a legacy with it, even better!