Since the introduction of pension freedoms, there has been a substantial move by clients and advisers away from the traditional annuity purchase at the point of retirement. However, many clients are still opting to receive all their tax-free cash at once. With all aspects of retirement becoming increasingly fluid, and many people working reduced hours, is this still the best option?
Advisers are starting to challenge the validity of clients taking all their tax-free cash in a single lump sum. This is to ensure their income needs are met in the most tax-efficient way, and to keep funds invested in the tax-sheltered pension environment for as long as possible.
Tax-free lump sums have often been taken to pay off outstanding mortgages or loans. But in many cases, they are simply taken just because they are available and appear to be an attractive option. However, if those funds are not required, they may then sit in a bank account, gaining little interest and being potentially taxable, and also potentially falling into the client's estate on death and being subject to IHT.
Another strategy is to phase the withdrawals by combining small, more regular amounts of tax-free cash and taxable withdrawals 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 tax-free cash as part of an income payment means that 25% will be tax-free, and less of the total withdrawal is subject to income tax. This not only saves the client tax, but has the potential to extend the life of their pension pot.
Drawdown is now a popular option; even for smaller funds. It could be considered that clients with more modest pots have an even greater need to make the most of their funds.
There are compelling reasons to consider using tax-free cash as part of a regular withdrawal to help boost total income.
For example, where clients are on low incomes, withdrawals can be managed to ensure as little income tax as possible is payable, by keeping taxable income below the personal allowance and making up the rest with tax-free cash. This will ensure the client receives the greatest benefits from their funds; potentially paying no income tax at all during retirement.
The opportunity to control a client’s tax liability by phasing income payments is not unique to those who have smaller pots. It can also be a valuable tool for all clients to help reduce their income tax liability.
In addition, where clients are wishing to gradually reduce their working hours in preparation for retirement, phasing benefits can help maintain an overall income should they decide to partially retire.
For example, a combination of income and tax-free cash could be used to top up income in the most tax-efficient way: particularly beneficial where the client’s income requirements are around the higher rate threshold. Using more tax-free cash at this point may be advantageous to limit the payment of higher-rate tax. They can then take a greater proportion of income when they fully retire and are subject to basic-rate tax.
One of the other key advantages of phasing benefits is that a client will retain more of their pension fund in the retirement planning or pre-retirement part of their pension fund. This means they will potentially increase the total amount of tax-free cash they receive from their pension fund.
When crystallising a client’s full pension entitlement at retirement and withdrawing all tax-free cash in one payment, no further tax-free cash will become available (unless they make further contributions). However, by phasing benefits there is the opportunity that the retirement planning or pre-retirement part of the pension fund will benefit from investment growth, and over time this will generate additional tax-free cash entitlement.