You’ve asked a financial advisor about temporarily topping up your earnings from your pension savings. He says there are two methods to do this. What are they and which of them is more tax efficient?
Ins and out
In general terms, there two main tax consequences of taking some of your pension savings while continuing to earn. First, it can limit tax relief for future pension contributions and, of course, increase your income tax bill. We’ll look at tax relief in another article and focus on the latter.
Annuities, lump sums and drawdowns
Depending on the type of pension plan you have it’s possible to take the whole of your fund at once, but this is usually too costly in terms of tax. The three main alternatives are to buy an annuity (an insurance product that pays you a regular pension for life); take a lump sum (tax-free cash, also known as a pension commencement lump sum (PCLS)) plus “drawdown”, or take uncrystallised fund pension lump sums (UFPLSs). An annuity isn’t a good choice if you want to vary or stop drawing on your pension savings so that leaves lump sum plus drawdown and UFPLSs.
PCLS plus drawdown and UFPLSs
Whichever you choose, 25% of your pension fund can be taken tax free. With PCLS plus drawdowns you get the 25% up front as a lump sum and all subsequent drawdowns are liable to income tax. By contrast, UFPLSs are a mix of tax free and taxable cash. 25% of each payment is tax free and 75% is taxable as income. Trap. If you take a UFPLS you can’t then take a PCLS plus drawdown from the same fund, and vice versa. However, if you have more than one fund you can take a UFPLS from one or more and a PCLS plus drawdown from the others.
Example – PCLS plus drawdown. You want £10,000 to top up your income. You have four pension plans worth £300,000 in total. One has a value of £42,000. You could take a tax-free lump of up to £10,500 from this and take the balance as taxable drawdowns as and when you want. Example – UFPLS. Instead, to get the £10,000 you can simply take that amount as a UFPLS. £2,500 will be tax free and £7,500 taxable. How much tax you’ll pay on this depends on how much other income you have. You can take other UFPLSs from the same pension fund when you want.
The right choice
The end result of taking tax-free cash plus drawdown or UFPLSs might seems the same, i.e. 25% tax free and 75% taxable but it’s not. Tax-free cash plus drawdown may be advantageous for two reasons. First, in the short term more value stays in your fund because you can usually take less to achieve the same net of tax income. Second, there can be significant tax savings. Example. Ahmed is a higher rate taxpayer but will be a basic rate payer when he stops working four years from now. Until then he wants to top up his earnings. His pension savings stand at £300,000 and he wants to receive enough to give him an extra £15,000 per year in his pocket for the next four years. To achieve this his pension advisor can split Ahmed’s savings into separate pension funds allowing him to take £15,000 tax-free cash from one fund each year. To get the same from UFPLSs Ahmed must take £21,430 from his fund. In the long run the tax-free cash option could leave Ahmed £13,000 better off.
You can take a tax-free lump sum of up to 25% of your pension fund and draw the remainder as wholly taxable income. Or you can take all your fund as lump sums each consisting of 25% tax free plus 75% taxable. If you’re a higher rate taxpayer now but expect to be a basic rate taxpayer later, the former method is more tax efficient.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.