In this article we are looking at taking benefits in phases, to help with this we’ll show the different impacts using a case study.
One way of taking money out of your pension pot a bit at a time is to take 25% tax-free cash at the start and move the remaining 75% into an income drawdown pot. With flexi-access drawdown the money purchase annual allowance isn’t triggered when you take the initial 25% tax-free cash, it’s only triggered once you take your first income withdrawal, from the 75%.
It’s worth remembering that not all pension plans can support income drawdown. This is especially the case with older plans. If that is the case the benefits should be transferred to a plan that can before crystallising benefits.
Another option is to take your tax-free cash gradually. Every time you take money from your pension pot, 25% of it is tax-free and tax is payable, at your marginal rate, on the other 75% of each lump sum. The money purchase annual allowance is triggered by the first payment of income benefits.
In this example Nabeel, aged 55, lives in England and is a higher rate taxpayer. He requires £20,000 to build a 'granny' flat onto his house as he can't afford to move to a bigger house due to the cost, in particular stamp duty.
He is still working and funding his pension and is at the age where due to his work experience his earning potential is fairly high. In turn his pensions contributions are significant and will also increase. He is currently paying £4,800 a year into his employer's money purchase pension plan, his employer matches this amount, so a total of £9,600 a year is being paid in. He also has another pension pot of £380,000 that is not being paid into.
He can transfer the £380,000 fund into a plan that offers drawdown and crystallise £80,000 giving him £20,000 (25%) tax-free. He doesn't need an income just now as he has enough to live on from his salary. As no income is taken this does not trigger the money purchase annual allowance allowing him to contribute as normal into his workplace pension and not be restricted to £4,000 a year before there is an annual allowance tax charge. No income tax is payable as he does not need an income from the pension savings at the moment. The house value will increase due to the extension and increases his estate for inheritance tax purposes, but the £360,000 left over is still in the pensions ‘tax wrapper’ keeping it outside his estate for inheritance tax.
He can take a partial UFPLS from the plan. This will trigger the money purchase annual allowance, which will restrict future pension contributions to £4,000 a year or there will be an annual annual tax charge. Because part of the payment will be taxable income Nabeel will have to crystallise more that the £20,000.
In this case it makes sense for Nabeel to use phased drawdown rather than an UFPLS.
Let's look at Nabeel again in the same scenario but aged 65 and retiring.
In this example Nabeel is now aged 65, lives in England and is currently a higher rate taxpayer, but will be a basic rate or non-taxpayer in the next tax year. He requires £20,000 to build an extension on his house so he has room for his new hobby in retirement.
He stops working at the end of the year in December and takes an UFPLS in April of the tax year after he stopped working. He will then have no earnings that will use up his personal allowance. He supplements his income by moving his workplace pension into drawdown, and will phase this so that he can utilise his personal allowance each year.
An UFPLS is an option as he has no intention paying into a pension so the money purchase annual allowance restriction of on the level of contributions does not affect him.
|PCLS via drawdown|
(Nil income higher rate taxpayer)
|Amount crystallised||£80,000||£20,572 before tax|
|Amount added to taxable income||£0||£15,429|
|Income after tax||£0||£14,8571|
|Total received||£20,000||£20,000 (£5,143 + £14,857)|
|Annual allowance for future contributions||£40,000||£4,000|
1 Emergency tax codes will normally apply resulting in an initial overpayment of tax; the calculations above shows the position once Nabeel has received his overpayment from HMRC. Nabeel’s full personal allowance will be used when his UFPLS is paid, meaning only £2,859 would be liable to basic rate income tax
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.