Using the tax-free cash lump sum to supplement regular income payments can offer advantages over the more traditional option of taking it all at once.
6 minute read
Pension Freedoms has led to many more customers opting for drawdown plans over annuities, however many clients are still choosing to receive all their tax-free cash as a one off lump sum. The option to receive a potentially large tax-free sum at the point of retirement clearly has attractions and fits in with the traditional view of planning a dream holiday, buying a new car or the more prosaic need to pay off debts. However, with changing patterns of working, clients may benefit from a more flexible approach and using a combination of tax-free cash and taxed income to provide them with funds, possibly as a supplement to other income from earnings, investments or defined benefits (DB) pensions.
Drip-feed drawdown can help ensure the client’s income needs are met in the most tax-efficient way whilst keeping funds invested in the tax sheltered pension environment for as long as possible.
There are of course many valid reasons why clients may want to take all the tax-free cash in one go but often it is taken simply because it appears to be an attractive option and without a specific need. If the funds are taken and then placed on deposit or into an alternative taxed investment plan they may not achieve the same returns they would have had they been left within a tax-efficient pension.
Drip-feed drawdown can provide an alternative option whereby withdrawals are phased and small, more regular amounts of tax-free cash and taxable withdrawals are taken to meet the need for income. This can minimise tax and potentially give rise to a greater value of total tax-free cash over time.
Using the tax-free cash as all or part of an ‘income’ payment means that anywhere between 25% and 100% will be tax-free. As less of the total withdrawal is subject to income tax, this both saves the client immediate tax and has the potential to improve how long the overall pot lasts. By paying less tax on withdrawals, particularly in the early years, it means more funds can remain invested and have a longer opportunity to produce further growth.
Drawdown is now a popular option even for smaller funds, often where the client has other retained benefits from previous employments. Customers with more modest pots perhaps have an even greater need to make the most of their funds and make sure they don’t pay any unnecessary tax.
Jon is 60 and has just left his employment and started to receive a DB pension of £3,500. He also has £90,000 of defined contribution (DC) benefits. He needs to supplement his DB income until he starts to receive his state pension. He is also considering returning to part-time employment at some point after an extended break. His current income needs are £15,500 a year.
In year one Jon withdraws £12,000 from his pension made up of £3,000 tax-free cash and £9,000 taxable income. The £9,000 plus his DB pension income of £3,500 use up all of his £12,500 personal allowance (2019/20), meaning the full £15,500 can be received free of tax.
If Jon had taken the full tax-free cash, or perhaps £12,000 of tax-free cash, to fund his income he would have ‘wasted’ his personal allowance and used up his tax-free cash unnecessarily.
An even worse outcome could have occurred if he had taken the tax-free cash, placed it on deposit and funded the income through drawdown only. He would then have also paid £700 of income tax unnecessarily (ie £3,500 X 20%).
Jon can continue to receive the payments each year and adjust the level of withdrawals as the tax bands change or if and when he decides to start working part-time.
Jon’s example demonstrates the perfect tax position, ie managing his funds so that he pays no tax at all along with the minimum use of his tax-free cash. However, the opportunity to legitimately control a customer’s tax position through drip-feed drawdown can also be a valuable tool for all clients to help reduce their income tax liability. This can be particularly useful where a client’s needs may vary, as people move more gradually into retirement with many reducing hours or stopping work entirely before receiving their state pension.
Kate is aged 57 and wants to start to reduce her hours and as such her current £55,000 a year income will reduce by £10,000. Her expenditure however, will remain the same for the next few years whilst she supports her children through university. Fortunately she has a substantial DC pension fund of £700,000 following a recent transfer from her previous DB pension scheme. She wants to access this to make up the shortfall.
The £10,000 income Kate wants to replace gave rise to £3,000 tax and generates a net income payment to her of £7,000. With the higher rate band for 2019/20 at £50,000, £5,000 was taxed at 20% and £5,000 at 40% meaning a total of £3,000 tax.
(Note: for simplicity the example does not account for Employee’s NI liability.)
There are a number of ways she could receive the required funds from the drawdown plan.
Crystallise £28,000 each year and pay out £7,000 tax-free cash. This option reduces the amount of immediate tax but will mean the tax-free cash will be used up far more quickly. In addition, as she is always likely to be at least a basic rate tax payer it will be a case of deferring tax to a later date on the crystallised income.
Crystallise £8,580. This would mean £2,145 of the payment will be tax-free cash. £6,435 will be subject to income tax. £5,000 of that will be at 20% and £1,435 at 40% meaning total tax of £1,574. This deducted from the crystallised amount gives £7,006, just over the required amount. Whilst this option uses the least tax-free cash it also means that Kate will be subject to higher rate tax on some of the withdrawals.
Crystallise £12,000. Pay out the £3,000 in tax-free cash, £5,000 in income and leave £4,000 invested in the crystallised fund. The £5,000 income uses up the rest of Kate’s basic rate band and will be taxed at 20% leaving £4,000. This together with the £3,000 tax-free cash provides her with a total of £7,000.
Option 3 optimises the use of tax-free cash ensuring the taxable withdrawal remains within her basic rate band.
All options can be used with drip-feed drawdown and tailored to the specific circumstances of the individual client. They can also be reviewed and adjusted as circumstances change. For example if Kate decides to reduce her hours further.
One of the other key benefits of taking the tax-free cash gradually is that a client will retain more of their pension fund in the uncrystallised part. The advantage of this is that they will potentially increase the total monetary amount of tax-free cash that they receive from their pension fund. As in the above example this needs to balance with the current income tax position of the client.
When crystallising a client’s full pension and drawing all tax-free cash in one payment, no further tax-free cash will become available (unless they make further contributions). However by spreading tax-free cash there is the opportunity that the uncrystallised part of the pension fund will benefit from investment growth, and over time this will generate additional tax-free cash entitlement.
A UFPLS can also be used to meet a client’s income needs through a combination of tax-free cash and taxable income. If the client only wanted to receive funds with 25% tax-free cash and 75% income then UFPLS payments can achieve the same outcome as drawdown. However, the UFPLS doesn’t provide any flexibility and there is no option to take tax-free cash only or any other combinations of tax-free cash and taxable income.
When planning for clients with substantial funds the Lifetime Allowance (LTA) also needs to be considered. The LTA increased in April 2019 to £1.055m. This is the second increase in eight years. Although modest, after substantial cuts this does signal that the inflation protection of the LTA is back. This could mean that taking all the tax-free cash without a specific purpose could also put the client at a disadvantage from an LTA perspective. This is because all funds moved into drawdown are then subject to a second LTA test, either at age 75 or earlier annuity purchase. Where clients have a reasonable income need this shouldn’t present an issue as any increase in the funds will usually be taken as income.
However, where the tax-free cash is taken and the rest of the funds are left in drawdown this would remove the inflation protection provided by any future LTA increases.
Note: Scottish taxpayers have their own income tax rates and bands which will affect the tax outcomes in our examples.
This information is for UK financial adviser use only and should not be distributed to or relied upon by any other person.