Welcome to the fifth article in How To Invest Your Pension for Income - an Investors Chronicle series designed to help DIY investors know the rules and make their pension investments work for them.
Not every investor in an income drawdown arrangement wants to take an income from their pension, so this week we're looking at what you need to consider if you're investing your pension to save for later, rather than spend it now.
If you have a decent-sized defined benefit (DB) pension, consider yourself lucky: gold-plated pensions are a dying breed. DB pensions (where your pension is related to your salary in employment and length of service) tend to be generous arrangements, and give you a guaranteed income; unlike defined contribution (DC) pensions (where the size of your pension pot is decided by your investment returns).
If you have a defined benefit pension that will provide you with as much income as you need to live off in retirement, and you have other pensions, either in a DC scheme or a self-invested personal pension (Sipp), then you might want to give serious consideration to leaving these pots untouched.
Whether you should spend your non-DB pensions or not depends on what is most important to you; enjoying your money now as pension income or as a lump sum, or leaving it behind as an inheritance for your beneficiaries. Most people's answer to this question will probably be 'a bit of both', but to make the decision that's right for you, you need to be aware that the minute you dip into your pension, it will affect your tax bill.
Taking the tax-free lump sum changes inheritance tax position
When they first reach retirement age, retirees are often eager to take their 25 per cent tax-free cash as soon as possible. This urge has been heightened after fears started to brew about the government potentially reducing the 25 per cent tax-free lump sum to allow retirees to grab a lesser chunk on a tax-free basis. Most people take it and save it in a cash account or individual savings account.
But if you take any tax-free cash from your DC pension or Sipp at all, this changes the inheritance tax treatment of your whole pension fund. If you die before age 75, and you haven't touched a penny of your pension, your entire fund can be passed on tax-free to your beneficiaries. Taking even 1p of pension payment, income or tax-free lump sum, irreversibly destroys this benefit. Therefore, if you take some, or all of it, the tax-free lump sum forms part of your estate and can be taxed at 40 per cent if your estate exceeds the threshold (£325,000 per person or £650,000 for a couple).
And with regards to what happens to the rest of your pension if you die, you'll be left with three options. The first is that your spouse can take on your pension and continue in drawdown without paying any extra tax. The second is that your spouse can use your drawdown money to buy an annuity if they would prefer a guaranteed income: again, there is no extra tax bill to pay for this. And the third option is to pass the money onto other beneficiaries as a lump sum, and accept a 55 per cent tax bill on the money.
To take advantage of your tax-free lump sum and protect some of your pension from a large tax bill if you die, you can use a process called 'phased drawdown', which allows you to 'cystallise' chunks of your pension (from which you can take your 25 per cent lump sum as you go), while leaving the rest protected from tax. There are no limits on how many chunks you can take, or over what time period, but Gary Smith, financial planner at Tilney Bestinvest, says it's important to use up your tax-free lump sum by the time you reach age 75, as it can be taxed at 55 per cent, if you die after this point.
Be aware of the age 75 rule
If you decide to leave your DC pension or Sipp untouched until you reach the age of 75, your whole pension can be passed on to your beneficiaries outside of your estate, free of tax. After you have reached the age of 75 your pension pot automatically 'crystallises', meaning you will have to pay 55 per cent tax on it when you die. However, the government is expected to reduce death tax on pensions in April; it has said it will reveal the details in the Autumn Statement.
However, if you are under 75 and you've decided to leave your DC pension or Sipp untouched to preserve the tax benefits, you still need to watch out for the £1.25m lifetime pensions allowance (unless you have already taken out protection). This is because any investment growth you receive on your pension in between retirement age and 75 will be added to your total pension value and tested against the lifetime allowance. Investment growth below the limit will not be taxed, but growth that exceeds the allowance will be taxed at 55 per cent.
Let's imagine a 65-year-old retiring today has a DB pension worth £1m (income of £50,000 a year times 20) and a Sipp worth £250,000), giving them a total pension of £1.25m. If they live off their DB income and invest their Sipp to double their money in 10 years (making £250,000 and providing a pension of £1.5m), they will be taxed at 55 per cent on the additional £250,000.
In particular, you need to watch out if you have either fixed protection 2012 (which means your pension can reach £1.8m before punitive tax is applied) or fixed protection 2014 (which means your pension can reach £1.5m before punitive tax is applied), because if you contribute even 1p into your pension, you will lose the protection, making you vulnerable to a potentially huge tax bill.
New rules around making further pension contributions
If you're approaching the lifetime pensions limit, the last thing you will probably be thinking about is making extra contributions. But if you're well under it, and currently in a capped drawdown arrangement (in which you're allowed to take pension income of up to 150 per cent of the GAD rate), you're still allowed to contribute £40,000 a year into your pension. If you want to continue to be allowed to make contributions up to this level, as long as you remain in capped drawdown, you will be allowed to do so, even after the new pension rules come into force in April 2015.
However, if you're in a flexible drawdown arrangement (in which you're allowed to take unlimited income from pension money above a level of guaranteed basic income of £12,000 a year), you are currently not allowed to make any contributions to your pension, and will face a 55 per cent punitive tax bill if you do.
However, from April next year people currently in flexible drawdown arrangements will be given the opportunity to contribute £10,000 a year into their pension, as long as the contributions are not deemed to have come from old 'recycled' pension money, which would effectively allow you to get double tax relief.
