April 2015 saw the introduction of pension freedoms. So, what does this actually mean for people who are looking to access their pension pot?
Prior to April 2015 the options available for the majority of people were very limited and in most cases an annuity would be the only option, offering a lack of flexibility and a poor deal especially with interest rates being at rock bottom.
The key benefits and changes of pension freedoms are outlined below.
You don’t have to purchase an annuity
Thanks to pension freedoms introduced last year, savers over the age of 55 are essentially able to do whatever they like with their defined contribution pension pot.
A defined contribution pension pot is one where you build up a pot of money that you can then use to provide an income in retirement.
Previously, you could access 25% in a tax-free lump sum, and then (usually) buy an annuity with the rest, which provided a lifelong income.
Now, you can take the whole fund in one go if you wish (something we don’t recommend), or alternatively you can still use it to buy an annuity or you can simply keep it invested and withdraw some money each year via income drawdown as and when required.
You could use a combination of an annuity providing secure monthly income and use the income drawdown for your flexible income requirements.
What are the options?
The three main options, based on having a £100,000 pension pot, are now as follows – based on taking a 25% tax free lump sum or £25,000:
- Take out the remaining £75,000 immediately, or in lump sums, and pay income tax at your marginal rate – 20%, 40% or 45%. It is important to note however that drawing a larger amount or taking all of the pension pot in one go means that the money received is treated as income in that tax year and could mean a large amount of tax being paid.
- Buy an annuity with the £75,000.
- Leave the £75,000 invested (Or the whole £100,000 including the tax free cash) in the pension fund and ‘draw down’ as much or as little as you want in income. This option however comes with the risk that drawing too much money can lead to running out of pension funds when this money may be needed to last a lifetime.
If you have a final salary pension (defined benefit) you have the option to transfer your savings over to a defined contribution pension in order to take advantage of the new rules. However, you should get independent advice before you do this as you’ll be giving up significant guaranteed benefits and will likely end up worse off.
Better flexibility with income drawdown
Income drawdown had traditionally been a route that only people with a larger pension pot had been able to consider, or those with a minimum level of other guaranteed pension income to fall back on.
It allows you to keep your pension fund invested in the stock market and take out an income as and when required.
The Pension Freedom changes mean that this is now an option for everyone and these arrangements are known as ‘flexi-access drawdown’ products.
This allows you to take out as much as you want each year (subject to tax) and no longer has a minimum income requirement. This therefore provides a better level of control and flexibility over your pension pot but, if not managed correctly, can lead to the pension pot running out of money.
Also, accessing a pension pot flexibly can lead to you only being able to contribute a lower annual amount to your pension.
The current annual limit is the lower of £40,000 or your net relevant earnings, where tax relief can be gained however this can fall to £4,000 a year if you access your pot flexibly.
Independent financial advice is therefore important when looking to explore this option.
Improved death benefits
Before Pension Freedoms came in, if you died and passed on your pension, it used to be subject to a whopping 55% ‘death tax’, unless you passed away before the age of 75 and had not taken any cash or income from your pot.
The new options that apply upon death are as follows:
- On death before age 75 the benefits can be paid as a lump sum or as a drawdown pension to any beneficiary tax-free, irrespective of whether they derived from uncrystallised or crystallised monies.
- On death after age 75 the benefits can be drawn down or paid as a lump sum taxed at the beneficiary’s marginal rate.
It is important to note here however that if an annuity is purchased without any death benefits selected at the outset (examples include guaranteed periods, joint life/nominee annuities and value protection) then the annuity will stop on death and no further funds will be paid to any beneficiaries.
With income drawdown on the other hand, any remaining funds left in the pension pot will be passed on to beneficiaries, therefore giving greater flexibility than an annuity. Some pension plans allow the beneficiary to keep the money invested in a beneficiary drawdown plan so that they can also benefit from a flexible pension in their lifetime, as opposed to having to draw all the money out when the other person dies.
Pension funds are also not subject to inheritance tax and sit outside of your estate, unlike other cash or property assets.
It is important to ensure that any pension plan has the correct beneficiary trust forms completed to ensure the money goes to the right people.
Review your pensions
Although the Pension Freedoms have many benefits, some older pension plans arranged before April 2015 do not allow you to access all of the benefits such as income drawdown. This means that you may need to change your pension plan to allow you to use all of the options that are now available. If you are approaching age 55 or are about to retire then it is a good time for an independent pension review.
A pension is a long-term investment not normally accessible until 55. The value of your investment (and any income from them) can go down as well as up which would have an impact on the level of pension benefits available. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.