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The relevance graveyard

Increasingly, individuals with occupational pensions are transferring to personal pensions to take advantage of the flexibility available with future funding and drawdown.

There is quite often a need to take benefits from a pension plan, particularly tax-free cash, without wishing to retire. A personal pension is the only vehicle that will allow this flexibility.

But tax-free cash in isolation cannot be taken from a personal pension. Where income is not required, the minimum drawdown amount can be taken and recycled into a second personal pension. This will have the benefit of generating a further tax-free lump sum at some future point and raise the level of future income.

On death before 75, the death benefit from the second personal pension will normally be free of inheritance tax. If the fund is exceptionally big, care will be needed to ensure that all the income can be recycled and, if necessary, the cash and drawdown limited to only taking benefits from some of the (usually 1,000) arrangements.

Taking advantage of the rules regarding the basis year and cessation of earnings, it is likely that for most clients the minimum withdrawal can be recycled in this way through to retirement and up to five years after earnings cease. Even then it is possible to recycle £3,600 up to 75.

Unfortunately, the planning can fall down if the rules are not understood fully and careful action taken along the way. For instance, let us assume that Ian has been a member of his employer&#39s money-purchase occupational scheme for 20 years up until retirement at 60.

He transfers his occupational scheme to a personal pension and takes the maximum tax-free cash and minimum drawdown with the intention of reinvesting the drawdown amount back into a second personal pension. The earnings used to justify contributions can be the earnings of the current tax year or any of the previous five. The year chosen is the basis year.

Table 1 (above) shows the contributions that Ian therefore thinks he can reinvest.

Unfortunately, it is only relevant earnings that can be used. Remember that earnings while being a member of an occupational scheme are not relevant earnings. This means that if Ian wants to make a contribution based on a basis year, he will be disappointed to discover that he does not have a year he can take into account and will therefore be limited to £3,600 gross (£2,808 net) – far less than the contributions he was hoping to pay.

However, with careful planning, Ian could have left his employer&#39s scheme one tax year before retirement and would then have had a full year&#39s worth of relevant earnings on which to base future contributions. He would not even need to lose out on pension benefits as his employer could have contributed to a personal pension for him during that last year although care would be needed to ensure that death benefits were not unduly affected.

In many cases, the contribution that is being paid into an occupational scheme would also fall within the limits of contributions to a personal pension and therefore Ian&#39s total pension fund from employer contributions would not necessarily be smaller although they could be spread over two pensions.

Similar problems would occur if the circumstances were slightly different. Let us assume that Andy is a controlling director who does not want to retire but is in need of some cash. Unless he is a pre-1989 member and has reached normal retirement date, it is not possible to take benefits under his occupational scheme without retiring. Andy therefore transfers to a personal pension. He can now have benefits any time from 50 onwards without the need to retire.

Andy takes the cash and, because he does not really want any income, he takes the minimum he has to by income withdrawal, with the intention of reinvesting via a second personal pension.

Andy thinks that he will have no problems contributing up to £20,000 a year for the next five years and, even when his earnings cease at 65, he will be able to take advantage of the rules regarding cessation of earnings and still be able to contribute up to £20,000 a year for a further five years.

Unfortunately, as soon as income is taken from a personal pension that has been transferred from an occupational scheme, Andy, being a controlling director, is in receipt of income indirectly from the occupational scheme of his current employer. This income is emoluments (under section 644(6A) TA 1988) and this has the effect of making his earnings from the same employer no longer relevant earnings. Andy now has no earnings on which to base contributions to a personal pension.

If Andy had moved on to another job unconnected with the job that was pensioned under the occupational scheme, the second source would be okay.

But in this example, Andy could not contribute based on net relevant earnings as he would not have any. He would be in receipt of S644(6A) emoluments from 60 onwards (no net relevant earnings) and was previously in his employer&#39s occupational scheme up to 60 (no net relevant earnings). The year of his 65th birthday is not a cessation year (the year when relevant earnings cease) because he never had any relevant earnings to cease. Andy would therefore be limited to contributions of £3,600 gross a year from 61 onwards, as shown in Table 2 (bottom).

However, if Andy left the occupational scheme and then transferred the benefits to a personal and delayed taking any income from the personal pension for a year, he would have a source of net relevant earnings for that one year on which to base personal pension contributions.

Although Andy would continue to have earnings until 65, those earnings after starting income withdrawals would not be relevant. The year of his 61st birthday would be Andy&#39s cessation year (a year when he ceased to have relevant earnings) and contributions could continue for five qualifying post-cessation years, as shown in Table 3 (above).

Any client who is over 50, is not planning to retire and therefore has no income requirement but wishes they could access a lump sum from their pension now has the opportunity to do that through a personal pension. Although the rules for the basis year and cessation of earnings can be confusing, one thing is clear – fully understanding the rules and possible pitfalls can ensure that clients take full advantage of the opportunities.

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