Pensions and tax efficiency

Ins and out

In general terms, there two main tax consequences of taking pension savings while continuing to earn. First, it can limit tax relief for future pension contributions and, of course, increase the income tax bill. We’ll look at the latter here.

Annuities, lump sums and drawdowns

Depending on the type of pension plan, it’s possible to take the whole of a fund at once, but this is usually too costly in terms of tax. The three main alternatives are to buy an annuity (an insurance product that pays a regular pension for life); take a lump sum (tax-free cash, also known as a pension commencement lump sum (PCLS)) plus “drawdown”, or take uncrystallised fund pension lump sums (UFPLSs). An annuity isn’t a good choice if the member wants to vary or stop drawing on the pension savings so that leaves lump sum plus drawdown and UFPLSs.

PCLS plus drawdown and UFPLSs

Whichever is chosen, 25% of the pension fund can be taken tax free. With PCLS plus drawdowns the 25% is paid up front as a lump sum and all subsequent drawdowns are liable to income tax. By contrast, UFPLSs are a mix of tax free and taxable cash. 25% of each payment is tax free and 75% is taxable as income. If an individual takes a UFPLS they can’t then take a PCLS plus drawdown from the same fund, and vice versa. However, if they have more than one fund they can take a UFPLS from one or more and a PCLS plus drawdown from the others.

Example - PCLS plus drawdown. John wants £10,000 to top up his income. He has four pension plans worth £300,000 in total. One has a value of £42,000. John could take a tax-free lump of up to £10,500 from this and take the balance as taxable drawdowns as and when he wants.

Example - UFPLS. Instead, to get the £10,000 John can simply take that amount as a UFPLS. £2,500 will be tax free and £7,500 taxable. How much tax he’ll pay on this depends on how much other income he has. He can take other UFPLSs from the same pension fund when he wants.

The right choice

The end result of taking tax-free cash plus drawdown or UFPLSs might seems the same, i.e. 25% tax free and 75% taxable but it’s not. Tax-free cash plus drawdown may be advantageous for two reasons. First, in the short term more value stays in the fund because members can usually take less to achieve the same net of tax income. Second, there can be significant tax savings.

Example. Ahmed is a higher rate taxpayer but will be a basic rate payer when he stops working four years from now. Until then he wants to top up his earnings. His pension savings stand at £300,000 and he wants to receive enough to give him an extra £15,000 per year in his pocket for the next four years. To achieve this his pension advisor can split Ahmed’s savings into separate pension funds allowing him to take £15,000 tax-free cash from one fund each year. To get the same from UFPLSs Ahmed must take £21,430 from his fund. In the long run the tax-free cash option could leave Ahmed £13,000 better off