Freedom and Choice – how much tax do you want to pay?

• Uncrystallised Fund Pension Lump Sums (UFPLS)

• Income drawdown, including Flexi-Access Drawdown (FAD), existing capped drawdown plans and short-term annuities

• Purchase an annuity

• Take a scheme pension

They have one thing in common. Whichever option is chosen it will be subject to income tax. In some ways the choice is about how quickly the saver is prepared to pay it.

UFPLS – taxed up front

This is the new and extremely populist move that provides savers over the age of 55 with complete freedom to do what they like with their pension benefits. Provided they are able to depend on other savings in the future, or to subsist on means-tested benefits, savers can even spend it all in one glorious spree if that’s what they want.

It is also a relatively easy option for providers to offer since it doesn’t require the systems and checks necessary to support ongoing income payments.

But there is a price – even though the UFPLS is paid as a lump sum, it is treated as income for tax purposes. And since all the money is received in one payment, all the tax is due for payment in one go too.

Each lump sum will be paid out net of the tax due by the scheme administrator. As only 25% is tax-free this can result in a significant reduction, particularly if the individual already has earned income in that tax year which uses up the personal allowance and lower rate tax bands.

Drawdown – income tax management

FAD provides the flexibility to manage the individual’s income tax bill. Unlike UFPLS, savers can take a tax-free lump sum of up to 25% of the fund at the start of the contract whether or not they wish to take income at that point, which is helpful if the individual has a one-off expense.

They can then manage their ongoing tax by carefully planning exactly how much income is withdrawn in each tax year.

Savers who do not need a lump sum up front also have the option to phase their withdrawals so that each payment contains a tax-free element.

Phasing withdrawal, under either UFPLS or FAD, has the additional advantage that the portion of the fund which is unspent may be used at a future date to provide more income, pay for additional or one-off expenses or provide a legacy to chosen beneficiaries.

Annuities and Scheme Pension – taxed over the lifetime of the plan

Both scheme pensions and annuities are designed to pay lifetime income. The pattern of payments is set at outset according to the choices made by the purchaser or scheme trustee at that time.

From 6 April it will be possible to set a pattern of income which either increases or decreases – or does both over time - and the options available on death have also been improved so that benefits can be paid to any chosen individual, not just those who are financial dependents.

From a taxation point of view this means that the income tax bill is effectively spread over the remainder of the individual’s life however there is very little scope to make changes if the individual’s circumstances change.

The major advantage of a scheme pension is for those who have savings in excess of the Lifetime Allowance (LTA). Under this option rather than the fund value it is the level of income that is tested against the LTA. The income is determined on an individual basis by the scheme actuary who is at liberty to include indexation and capital/income protection options which can reduce the level of initial income and effectively “soak up” some of the excess savings. In all other aspects it is similar to an annuity.

Summary

There is no doubt that Freedom and Choice has made pensions seem more attractive to the average saver, however it does mean that there will be some difficult and crucial decisions to make at retirement. Tax is only one of the factors that must be taken into consideration and every individual will have different needs and priorities. Financial advisers are ideally placed to help people assess their needs and provide a recommended course of action.

Fiona Tait is Business Development Manager at Royal London

More information regarding the changes to pension legislation can be found on Royal London’s website: www.royallondon.com