Getting more from pensions

John Lawson discusses how new pensions rules are increasing flexibility

The coalition is pressing ahead with changes to pension retirement benefit rules from April this year rather than next. Although the rules are potentially operational from April they will not become law until Royal Assent of the 2011 Finance Bill in July.

The changes will sweep away alternatively secured pensions and replace them with a new form of capped income drawdown that will run from age 55 until death.

Withdrawals will range from 0 to 100% of the basis amount, which roughly represents the single life annuity that can be bought with a fund at any given age.

Alongside the new capped drawdown rules, it will become possible to take withdrawals above 100% of the basis amount, called flexible drawdown, as long as the scheme member can prove that they meet a £20,000 minimum income test.

This test requires guaranteed lifetime income from pensions only – scheme pensions or lifetime annuities from registered pension schemes or state pension income. Purchased life annuities and variable annuity income will not count as both are capable of surrender, in the latter case the guaranteed income option rather than the whole plan.

Impact of death benefits

Where I think the changes are most interesting is in relation to death benefits. As things currently stand, undrawn benefits before age 75 are not subject to any special pension tax and are generally free from inheritance tax. Before age 75, drawn benefits (unsecured income) are also tax free if inherited by a spouse or a dependant as a pension fund, but are subject to a pension tax charge of 35% if paid to the deceased’s estate. Like undrawn benefits, inheritance tax will not normally apply.

After age 75, all benefits must become drawn, are tax free if inherited by a spouse/dependant as a pension fund or as a lump sum to a charity. But they can’t be passed to the estate, only inherited by another member of the same pension scheme in which case a 70% pension tax charge applies. Any fund subject to the 70% charge is also part of the estate for inheritance tax resulting in a total effective charge of 82%.

The new death benefit rules replace the 35% and 70% pension tax charges for drawn benefits with a single charge of 55% regardless of when death occurs. Two other changes are also notable: pension funds can be passed to the estate of the deceased on death after age 75; and, pension funds will now be free of inheritance tax whenever the member dies.

At first glance, passing your pension on as an inheritance does not look that attractive. It will after all be subject to a 55% tax hit (except for death under 75 where benefits are undrawn) even if it is free from inheritance tax.

A different perspective

But first impressions can be misleading. Pension withdrawals can be gifted away without IHT consequences, if it is a gift from surplus income and meets the criteria. The alternative to gifting pension withdrawals or leaving your pension fund untouched is flexible drawdown. Given that you will already need an income of £20,000 to take excessive withdrawals, the bulk of these withdrawals will probably be taxed at 40% or even 50%.

As soon as you take the money out, your tax efficient investment choices are limited. You can’t put the money back into your pension because further pension funding is prohibited as soon as you take flexible drawdown. You could put it in an ISA, but investment limits mean they will be unable to soak up much of any large pension fund withdrawal. Therefore, there is a good chance that your withdrawn fund will end up in a net roll-up wrapper such as an OEIC or an investment bond.

Another major drawback is that inheritance tax will immediately apply to drawn funds if your estate exceeds the nil-rate band. For example, if you had £100 in your pension, on death after age 75, £45 of it could be paid to your estate. But, if you take a flexible withdrawal, you will probably have to pay 40% income tax on the way out, turning £100 into £60 with the remainder subject to a further 40% inheritance tax, leaving your estate with only £36. So, even if you ignore the disadvantage of net roll-up, it would appear to make good sense to keep any money you want to pass to your estate inside your pension. 

Another huge advantage is control. Your pension fund continues to belong to you.

John Lawson is head of pensions policy at Standard Life