Income Drawdown Changes

There is a glimmer of good news on the pensions front, amid the general financial gloom.

The final details have yet to be circulated by the government, however information recently obtained shows that from April 6, a new pension creature will be released.This will be of particular interest to the higher end of the market as it takes the form of flexible draw-down which will apply to all those whose pension income totals over £20,000.It also gets rid of the need to purchase an annuity at age 75, the only alternative to which was the ASP - Alternative Secured Pension - which had very little merit except to those with a religious objection to buying an annuity.

The current draw-down system, where the pension pot remains invested and money is pulled out, scores high on flexibility and low on cost and risk, and this carries on in a slightly altered form to be known as capped draw-down with possibly a lower percentage withdrawal permitted.But it is the flexible draw-down that is really interesting. With a total pension income from other sources of £20,000 per annum, there will be no limit on the amount that can be taken as draw-down from the pot.

The logic behind the move is that there is little chance of those with £20,000 of conventional pensions from elsewhere falling into the state benefit system. The £20,000 can be made up of the state pension, company pensions or a privately bought annuity - however for some reason this must be bought with pension money.

Though not particularly popular, for someone with no money in a pension but a large amount of cash in the bank, purchased life annuities can be bought to provide an income for life but this cannot count towards the £20,000. Even though the government has not yet released the small print, I believe this new draw-down legislation is a big step in the right direction. Your pension pot is your money and where previously the government told you how to use it, now you have a choice.Those of us in the finance industry thought in the first instance that the government would say you must buy an inflation proof annuity, which is horrendously expensive, but that isn't the case, you are free to buy a level annuity to meet the £20000 pa test, which is much cheaper.

It is therefore going to be attractive to a lot more people, though still only to those at the upper end of the scale. It means that someone with the maximum state pension of about £10,000 a year who has got perhaps £300,000 in a pension pot is probably going to have to use about £140,000 of this to buy a level annuity to provide an income of £20,000 a year.Of course you could then remove all your remaining pension pot in one transaction although there is a strong income tax argument not to do this. This is because anything taken out is added to other income to calculate income tax so a lump sum could take you into the 40% tax bracket or even higher. However, the fact that you can take it all out is a huge step forward.The most tax efficient way would be to take out an amount that will keep you just under the 40% threshold, probably £42475 in 2011/2.Another consideration, with the £20,000 income in place, is whether to extinguish the pot so that tax is minimised when the last beneficiary dies. With some fairly standard investment planning, you could run the pot down without compromising income. Of course, if you live longer than you planned for, you could run out of money!

The old draw-down rules were designed to prevent depletion of funds so this is another step forward.One of downsides of the new legislation is that the tax on pension funding draw-down on death is going up to 55% from 35%. This seems to me to be a bit vindictive though tax breaks were specifically designed to protect people in retirement. They were never meant for succession planning or inheritance planning so the government obviously wants to claw back tax on death - though 55% seems like getting more than their pound of flesh.It does reinforce the wisdom of running the pot down and ensuring you don't leave a great deal in there when you die. If you pull it out and it is left in your estate, the worst it can attract is 40% inheritance tax. Gifting lump sums should be exempt if you live 7 years from the gift.If you draw it out as income, you can gift the excess tax-free so long as it doesn't affect your lifestyle. You can give away £3000 annually but this would be in addition to that amount so it makes sense to give away any surplus income.

Although we have not talked through all the implications, I believe the gift of excess income will probably be used more frequently and it looks as though there will also be opportunities in relation to inheritance tax as well as in retirement planning.


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Paul Duckworth is a Chartered Financial Planner and Fellow of the Personal Finance Society, licenced to advise UK residents. He specialises in Retirement Planning, Investment, Tax Planning and advising business owners.