Whilst it may seem a long time ago, the Budget of 2014 heralded the most significant change to the pensions system seen in generations. Pension Freedoms, the term used to describe these changes, gave retirees more choice over both the investment and use of their retirement savings than ever before. For many, pensions were transformed from a retirement income generator to an estate planning tool, allowing assets to pass tax efficiently to the next generation. However, when considering retirement it is important to consider the full range of pension options now available, how to fund retirement and how to pass pension assets to the next generation. Here we consider the opportunities available from different pension types.
Defined Benefit (DB) Schemes – whilst new DB schemes are rare, many older schemes remain in existence.
Benefits are determined by reference to length of service and salary rather than by investment growth and contributions made. These schemes offer a pension commencement lump sum (tax-free) which reduces the pension payable to the scheme member. There is flexibility, within certain limits, to increase or decrease the pension commencement lump sum at the expense of the ongoing pension.
The scheme pension payable for the life of the member will be liable to income tax at their marginal tax rate. Scheme rules and legislation determine annual pension increases and the continuing benefits following the member’s death; in most cases, a pension to the surviving spouse for the remainder of their lives, liable to income tax.
Pension Freedoms do not apply to these types of schemes and so very little has changed in recent years. They remain a valuable retirement planning vehicle, offering a guaranteed income.
Defined Contribution (DC) Pension Schemes – including personal pensions – were most affected by the 2014 changes. These schemes are comprised of contributions made by individuals and/or employers which have been invested. The pension benefits payable are determined by the value of the fund at the time the pension benefits are drawn and by the pension vehicle through which those benefits are enjoyed. The accumulated fund can be used in a number of ways:
Pension Annuity – purchased by the member or the pension scheme to guarantee the member an income for life. A standard annuity will be paid on a level or increasing basis, although increases can be determined by indices such as the Consumer Price Index or Retail Price Index. It is also possible to add other options such as guarantees for ongoing payment after the member’s death. Those in ill health or with pre-existing medical conditions may be eligible for an enhanced annuity and should discuss this with their adviser.
Flexi Access Drawdown (FAD) – gives the greatest flexibility of all the pension retirement options but comes with some risk. It allows a member to choose any level of income they wish from their pension fund; how long the fund lasts will depend upon the amount of income taken, the investment growth and the amounts that remain, as well as charges.
The pension fund can be crystallised in whole or in part. Ordinarily, 25% of the pension fund is paid tax-free (the pension commencement lump sum) with the remainder of the crystallised amount being paid out at any time, liable to income tax.
Capped Drawdown – although not available to those taking benefits for the first time after 6 April 2015, additional funds can still be added to capped drawdown if it has already been used by an individual. Capped drawdown does not offer the same flexibility as FAD as there are restrictions on income levels that are reviewed on a regular basis.
Uncrystallised Funds Pension Lump Sum (UFPLS) – this provides flexibility to those in pension schemes that do not offer drawdown. Each drawdown provides 25% of the lump sum tax-free and 75% of the lump sum taxed as income.
The benefit of UFPLS is that it is paid as a lump sum and the remainder of the fund in the pension will still be uncrystallised and available at a later date.
Benefits of Passing on Your Wealth
On death, any funds remaining within pension arrangements can be paid to nominated individuals, either by a lump sum or income.
The taxation of these ‘death benefits’ is dependent on the member’s age at the point of their death. The funds will be free from income tax on death prior to the age of 75 but on death at 75 onwards, the funds will be taxed as income on the beneficiary at the point at which the funds are drawn. The fund value on death can also be paid out to a trust if appropriate. Different tax charges apply in this situation.
Inheritance Tax (IHT)
Importantly, the vast majority of pensions remain outside the scope of IHT. Families should, where possible, consider using non-pension assets otherwise liable to IHT on death, to fund retirement. This is particularly relevant now as we are in the midst of a boom period for IHT receipts. HM Revenue & Customs received £5.2bn in IHT in the last tax year. This has been rising rapidly over the last seven years and is nearly double the £2.7bn IHT receipts in 2011. Put simply, many families may be paying far more tax than they need to on their estate because they are not making the most of pension freedoms.
Pension Freedoms heralded an era of considerable flexibility in both retirement and estate planning prompting families to consider:
Planning for retirement, whatever that means to you, is important and we always recommend taking professional advice.
For further information please contact your usual Brown Shipley Adviser.
Rebecca Williams // Client Director
Rebecca provides advice on risk management, investments, retirement solutions, estate planning and lifetime cash flow planning. Rebecca has particular experience of using lifetime cash flow with clients to help structure their affairs tax efficiently and plan to meet future goals.
Our Wealth Planning Service can involve investing your capital, which places it at risk. Investment risk means the value of your investments or any income can fluctuate and you may not get back some, or the entire amount invested. We recommend our clients seek professional tax advice to understand their personal liability for investment income or gains. This will depend on personal circumstances and the prevailing tax rules, which are subject to change