The 6 April 2015 saw the implementation of wide-ranging pension reform. This briefing note summarises the more significant changes.
Key changes to state pension reform from 6 April 2015
- The removal of limits when taking income from defined contribution pension schemes.
- Reduced annual allowance of £10,000 for individuals using the new flexibilities.
- More generous tax treatment of pension death benefits.
- A requirement for financial advice when transferring from defined benefit (final salary) pension schemes to defined contribution (money purchase) pension schemes.
- A ban on transfers from unfunded defined benefit to defined contribution schemes.
- More flexibility for new and existing annuities.
- The introduction of free guidance at retirement.
Options for taking Income after 6th April 2015
- Lifetime annuity
- Flexible annuity (can reduce in payment)
- Flexi-access drawdown
- Uncrystallised funds pension lump sum
- Scheme pension
- Small pots
- Trivial pension (final salary pensions only)
Pension income is taxed at your marginal rate
Understandably, the area of reform to attract most attention is the ability to take your entire defined contribution pension fund as a lump sum when you reach the minimum age (currently 55).
However this needs careful consideration before taking any action. Any withdrawal of pension fund (other than tax-free cash) may be subject to income tax at 40% or even 45%.
The following example shows the potential tax consequences of withdrawing your entire pension as a lump sum.
Example: Flexi-access drawdown
Consider an individual who chooses to take their entire pension fund of £200,000 as a lump sum.
- 25% of the pension can be taken as tax-free cash, so the first £50,000 will be tax free.
- The individual has no personal allowance.*
- So the entire balance of £150,000 is subject to income tax at marginal rate.
- £31,785 is taxed at 20% = £6,357
- £118,215 is taxed at 40% = £47,286
- Total tax paid = £53,643,
Tax reduces a pension fund of £200,000 to only £146,357. Had the person instead opted for a series of smaller lump sums, they may have benefitted from a lower marginal rate of income tax and paid less tax overall.
*2015/16 personal allowance is £10,600, but reduces by £1 for every £2 of income above £100,000 so the entire personal allowance is lost. For simplicity, we have assumed no other income sources.
Pension death benefits
Changes to the tax treatment of pension death benefits are, on the face of it, become considerably more generous.
- Death before age 75 – lump-sum death benefits and income will be untaxed regardless of whether tax-free cash and/or income has been taken.
- Death after age 75 – lump sums will be taxed at 45% in 2015/16 but thereafter it is proposed that they will be taxed at the marginal rate of the recipient. Income will be taxed at the marginal rate of the recipient.
- Additional classes of beneficiary to include non-dependents. So grandchildren, for example, could receive a lump sum or regular income, free of tax where the member dies before age 75, or taxed at their personal rates where the member is aged over 75 at death.
It may be sensible to review your pension death benefit nomination. Furthermore it may also be appropriate to review any wider IHT planning.
Defined Benefit Pensions (final salary)
Members of Defined Benefit schemes will not be able to take advantage of the new income flexibility.
To access these flexibilities members will need to transfer their benefits to money purchase arrangements.
However not all members of Defined Benefit schemes will be allowed to transfer to a money purchase arrangement. As a general rule:
- Private company schemes – allowed
- Funded public sector schemes – allowed
- Unfunded public sector schemes – not allowed
A transfer from a Defined Benefit scheme can result in the loss of very valuable pension benefits. So the government has stipulated that you must receive financial advice in respect of any such transfer.
Legacy pensions (money purchase)
Whilst the new rules permit all existing money purchase pension contracts to offer the new flexibilities, not all pension providers will choose to do so.
You may therefore need to consider moving your pension to a newer contract if you wish to take advantage of the new flexibilities.
Lifetime Allowance Reduction (2016/17)
Although not directly part of the pension reform legislation, George Osborne announced a reduction in the lifetime allowance for pensions in his March 2015 budget.
The reduced allowance will be £1million and takes effect from 6 April 2016. This follows a general trend of reduction of the life time allowance which was reduced from £1.8 million to £1.5 million in 2012/13 and reduced again to £1.25 million in 2014/15.