In Focus: TaxApr 22 2021

Why it pays to do proper pension planning

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Why it pays to do proper pension planning

Pensions are one of the most tax-efficient investments available for UK savers, but many people do not understand their importance.

This is the view of Fiona Tait, technical director for Intelligent Pensions, who told FTAdviser In Focus that, too often, the need for proper pension planning both before and after retirement is neglected. 

Tait said it is vital for consumers to seek professional advice about the best way to manage their pension pots tax-efficiently after retirement. 

FTAdviser: How important is tax planning post-retirement?

Fiona Tait: Pensions are probably the most tax-efficient investment available in the UK – so long as you keep your money invested. 

This makes sense given that the government wants to encourage people to save towards their own retirement, but it is equally true that the government doesn’t want people to spend it too fast once they’ve saved it either. 

Much will depend on what type of investments people hold and whether they are accessible or not.

They put the brakes on spending by applying tax charges, which kick in when benefits start to be taken.

Essentially, the faster it is spent they higher the tax bill is likely to be and it is therefore important for those who are just starting to access their pension to consider when and how they take their money to avoid paying more tax than necessary.

FTA: What is the key to managing the tax bill at retirement?

FT: The key to managing the tax bill at retirement is, where possible, to pay careful attention to the order in which investments are cashed in.

The first and most obvious option is to make use of the pension commencement lump sum, which may be withdrawn from a pension tax free.

For personal pensions and other defined contribution schemes this is usually worth 25 per cent of the overall fund value, but it is important to check whether there are any protections in place that may allow higher amounts to be paid tax free. 

The PCLS may be taken as an up-front lump sum or over time as part of an annual income.

For people who want to keep saving after they have taken money from their pensions, the lump sum option is likely to be preferable as it does not trigger the money purchase annual allowance, which restricts the amount that can continue to be paid into a pension plan without attracting further tax charges.

For those who want the maximum income possible it makes sense to use the PCLS to reduce the taxable amount in each year.

FTA: You mentioned the MPAA; what other tax charges could hit the unwary pensioner?

FT: People should also look out for any additional or unexpected one-off tax charges. If the value of pension savings exceeds the lifetime allowance, currently frozen at £1,073,100, there will be an LTA tax charge of up to 55 per cent.

This may be avoided by applying for protections prior to retirement, and/or mitigated by taking the excess amount in the form of an income instead of a lump sum.

If the excess is designated to pay income it will be taxed at 25 per cent, even if the fund is then fully withdrawn under the flexi-access drawdown rules at a later date, as that withdrawal would in itself be subject to income tax.

People should also be aware that the first income withdrawal from their pension is likely to be taxed under the emergency rate of income tax.

This means the tax code for this income will be set on the assumption that the initial amount is the first of a regular income stream, even if it is actually a one-off payment.

It is possible therefore for the tax code to be based on an amount which is up to 12 times the value of the actual withdrawal. The excess tax will eventually be refunded but it can come as a nasty shock at the time.

The easiest way to avoid this situation is by withdrawing smaller amounts at first and increasing income once the tax code has been confirmed. 

FTA: How can pensioners get up to £30,000 a year without getting hit by tax?

FT: For people who are fortunate enough to have a range of investments, the most tax-efficient order of encashment after the PCLS is:

  • Isas, where all withdrawals are free of tax (apart from the Lifetime Isa if money is withdrawn before age 60 and not used for a first home). Using the Isa allowance of £20,000 each year makes sense not just in the year of investment but also when it comes to withdrawing money in retirement.
  • Income-producing investments up to the value of any unused personal allowance, and the savings allowances for the year. For an individual with no other taxable income this could add up to an annual amount of £17,500 each year.
  • Utilising the dividend allowance could add another £2,000 of tax-free income.
  • Capital assets up the value of the annual capital gains tax exemption of £12,300. 
  • Taxable investment assets.

Then, and only then, taxable pension income. Not only is this income taxed when it is paid out, but any money left in the pension fund is almost certain to be free of inheritance tax on death, so it makes sense to leave as much there for as long as possible. 

FTA: Is tax the only consideration in pension planning?

FT: Of course tax is not the only consideration, and much will depend on what type of investments people hold and whether they are accessible or not.

Some investments carry early encashment penalties and others, such as rental property, may not be easy to dispose of.

It is, however, worth considering the eventual order of encashments, both when building up a savings portfolio and when starting to spend it. 

Simoney Kyriakou is senior editor of FTAdviser