One of the most talked about recent changes to the retirement rules is the introduction of flexible drawdown. The ability to cash in their entire pension fund is a huge attraction to clients, allowing them to use their retirement savings as and when they wish. However, the rules surrounding flexible drawdown means it will only be available to a small minority. And these people will need help working out how and when to use this new option.
Flexible drawdown can only be used by people age 55 and over who have at least £20,000 a year in secure income that is income in payment from state pensions, pension annuities and scheme pensions.
It does not include any income which isn’t guaranteed for life such as investment income or earnings. Those fortunate enough to meet this threshold can cash in the remainder of their pension fund as and when they wish. The caveat is that amounts over and above the normal tax-free lump sum will be taxed as earned income.
Research suggests around 200,000 people in the UK aged between 55 and 75 will be able to take advantage of flexible drawdown. These people are likely to be wealthy, with other sources of income in retirement and sufficient assets to make inheritance tax a concern.
At first glance, cashing in the whole pension fund over and above that needed to provide the £20,000 minimum income sounds attractive.
But paying 50 per cent income tax on some or all of it, as many will need to do without appropriate planning, casts a different light. And without any action, once the money is removed from the pension, it will be part of the individual’s estate when they die and therefore liable to IHT.
The table above highlights this key interaction between income tax and IHT.
If funds are left in a pension, then on death after age 75, a tax charge of 55 per cent is levied. In comparison, withdrawing funds will produce a better result if IHT can be avoided.
This is especially so for those liable to 20 per cent or 40 per cent income tax. Paying 50 per cent income tax to extract money, even if IHT can be side-stepped, is more debatable, especially as money remaining in the pension fund grows in a tax-efficient manner. So, withdrawing money in chunks to minimise income tax a form of accelerated drawdown may be a better course of action than taking it all at once.
However, if the money falls into the estate for IHT, leaving the money in the pension may be a better option from a tax perspective, irrespective of the income tax paid on withdrawals. At the extreme, high income tax along with inheritance tax can wipe out 70 per cent of the pension.
So people will need help minimising income tax and sheltering withdrawals from IHT and this is where financial advisers are well placed to add value. There are a host of options to minimise IHT from spending the money to gifting income to family.
Other options include putting the money in a suitable trust, so retaining an element of control, or paying the withdrawals into pension plans set up for children and grandchildren.
For the many people who are not in a position to use flexible drawdown, the table still has relevance.
For them, the ability to take the whole pension pot at once is not available, so the likelihood of paying 50 per cent income tax on withdrawals is slim.
However, the option of stripping income out as fast as possible, while minimising the income tax paid, then sheltering any unneeded withdrawals from inheritance tax can be a valuable planning tool.
To strip out income, people need a retirement income vehicle that allows high and flexible income this has traditionally been drawdown but as a result of the various changes in April, many people will now be able to withdraw a higher income from vehicles such as asset-backed annuities, especially if they meet the criteria for an enhanced income.