Uncrystallised fund pension lump sum versus income drawdown
Please note:
- The lifetime allowance charge has been removed from 6 April 2023 and the lifetime allowance will be removed completely from 6 April 2024.
- From 6 April 2024 tax-free cash will be restricted to £268,275 unless an individual has tax-free cash protection.
- The money purchase annual allowance increased from £4,000 to £10,000 from 6 April 2023.
There are a number of different ways to take money out of your pension fund. But depending on the route chosen, the age of the individual, the tax implications and impact on future pension savings will be different.
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.
Tax-free cash only
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.
Partial 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.
Case study one
- working
- higher rate taxpayer
In this example Nabeel, aged 55, lives in England and is a higher rate taxpayer. He requires £20,000 to build a conservatory 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 £6,000 a year into his employer's money purchase pension plan, his employer matches this amount, so a total of £12,000 a year is being paid in. He also has another pension pot of £380,000 that is not being paid into.
Partial/phased drawdown
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 £10,000 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.
- Income withdrawals from a flexi-access drawdown pension trigger the money purchase annual allowance.
- All the payments made in excess of the tax-free cash are taxable via PAYE.
- Unused funds remain invested and therefore subject to investment risk.
- There is a possibility that entire fund could be depleted and leave him with insufficient funds to live on in retirement.
Uncrystallised fund pension lump sum
He can take a partial uncrystallised fund pension lump sum from the plan. This will trigger the money purchase annual allowance, which will restrict future pension contributions to £10,000 a year or there will be an annual allowance tax charge. Because part of the payment is taxable income, Nabeel must crystallise more that the £20,000.
In this case it makes sense for Nabeel to use phased drawdown rather than an uncrystallised fund pension lump sum.
Case study two
- retired
- non-taxpayer
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 after he retires. He needs £20,000 to convert his garage so he has room for his new hobby in retirement.
He stops working at the end of the year in December and takes an uncrystallised fund pension lump sum 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 uncrystallised fund pension lump sum is an option as he has no of intention paying into a pension so the money purchase annual allowance restriction on the level of contributions does not affect him.
| Tax-free cash via drawdown (Nil income higher rate taxpayer) |
UFPLS (non-taxpayer) |
|
|---|---|---|
| Amount crystallised | £80,000 | £20,572 before tax |
| Tax-free amount | £20,000 | £5,143 |
| Amount added to taxable income | £0 | £15,429 |
| Crystallised fund | £60,000 | £0 |
| Income after tax | £0 | £14,8571 |
| Total received | £20,000 | £20,000 (£5,143 + £14,857) |
| Annual allowance for future contributions | £60,000 | £10,000 |
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 (currently £12,570) will be used when his uncrystallised fund pension lump sum is paid, meaning only £2,859 will be liable to basic rate income tax.
Disclaimer
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.