You’ve reached the age when you can access your pension savings. Your financial advisor has explained the options available to you, but how much tax will you have to pay on each one?
Tax efficiency factors
For money purchase type plans, i.e. your pension is not a final salary scheme, the answer to the question above is, “it depends”. There’s no single right answer to which method of taking your pension savings is most tax efficient because factors such as whether you intend to keep working, have other income, will continue paying pension contributions etc., all play a part.
Trap. The first factor to take account of is whether you intend to continue paying into a pension after you have accessed your existing pension savings. In many, but not all, cases this can limit tax relief to contributions of just £4,000 per tax year .
Pension options
Your options for accessing your pension savings fall into three broad types: buy an annuity (a lifetime pension), take a tax-free lump sum of up to 25% of your pension savings and either leave the rest invested or take it as income, or take uncrystallised fund pension lump sums (UFPLSs) as and when you want them.
Annuities. If you buy an annuity you cease to have control of the money and the annuity company pays you a regular income for life which is wholly taxable. Annuities have become unpopular over the last decade as they are inflexible and the rates of income offered are relatively low.
UFPLS. If you take a UFPLS you continue to have control of the remainder of your pension savings. 25% of each payment is tax free and the balance is taxable as income.
Tax-free cash. If you take tax-free cash, again you have control over the remainder of your savings, which you can draw as taxable income when you want. This is known as “drawdown”.
Trap. If you take a UFPLS you can’t then take a pension commencement lump sum (PCLS) plus drawdown from the same fund, and vice versa.
Tip. You can avoid the Trap and get the best of both tax-free cash plus drawdown and UFPLSs by splitting your pension savings between different pension plans. Alternatively, many pension companies offer so-called segmented funds. This is a single pension fund. That’s divided into smaller funds which, for tax purposes, are each treated as if they were separate pension plans. Their advantage is that you can take PCLSs from each segment as and when you want. This emulates the advantages of UFPLSs but you don’t have to draw any taxable income at the same time.
Rule of thumb
Although there’s no right answer to which option is the best, as a rule of thumb, if you want to draw on your pension savings while still earning, PCLSs (without taking drawdown) are more tax efficient as they won’t limit tax relief. Conversely, if you don’t need a significant amount of income immediately, UFPLSs can work better because they leave more of your pension savings to grow tax free in your pension.
A pension commencement lump sum tends to be more tax efficient if you intend to continue working and paying into a pension. This avoids limiting tax relief on future contributions. While there are some advantages to taking uncrystallised fund pension lump sums instead, these can be emulated by dividing your pension savings into separate funds and taking tax-free lump sums from each as and when you need them.
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.