Techzone

How and when to take tax free cash from a pension is a decision facing an increasing number of clients* as the popularity of drawdown continues at the expense of annuity purchases.

Modern flexible drawdown contracts offer many planning opportunities to get the most from savings and minimise tax - opportunities that weren’t available to most clients when they joined their pension and when tax free cash was the once in a lifetime reward at retirement.

In this article, we bust some of the myths to help you deliver the best strategy for your client’s circumstances:

Myth 1 - Always take your full tax free cash at the earliest opportunity
Myth 2 - It's more tax efficient to use tax free cash first to provide an income
Myth 3 - UFPLS gives clients all the flexibility they need
Myth 4 - You can’t take tax free cash after age 75
Myth 5 - Take tax free cash to help reduce LTA charges

Myth 1 - You should always take all your full tax free cash when you retire.

Taking the full 25% tax free cash entitlement in one go may still be attractive to some clients. They may have long earmarked the cash for a particular purpose, such as special purchase or to pay off mortgage debt.

Others may simply take the cash in one go, because that was their expectation when they started saving and annuity purchase was compulsory.

But with flexibility comes choice and the possibility to change behaviours that were previously seen as the norm.

Can that special purchase be funded from other savings? Using non-pension savings to purchase that holiday home would be IHT neutral. The client is simply using savings subject to IHT to buy another asset subject to IHT. But if the purchase is sourced from pension tax free cash, this is converting an IHT free asset into one which is now potentially subject to IHT.

And what if the tax free cash is taken but not spent or gifted? It makes no sense to withdraw an amount from a tax-efficient arrangement, simply to invest in an asset which is itself subject to further tax. It also removes the IHT protection that the pension wrapper provides. Most other investments will be included in the estate and what could be passed to the next generation could be subject to 40% IHT.

Before clients spend a quarter of their pension fund, they need to be sure that what they have left will support their income needs throughout their retirement. Tax free cash could be an important component in providing a client with the income they require.

Once all tax free cash has been taken, all future pension withdrawals will be fully taxable. And that could mean more tax in the long term.

Myth 2 - It's more tax efficient to take tax free cash before taking any taxable income.

Of course, it is possible to only take tax free cash to meet income needs. This strategy could be used in the early years of retirement until all the tax free cash entitlement has been exhausted**. This means only withdrawing exactly the amount to meet the immediate income needed with no tax to pay.

But it's important to consider not just what gives the least amount of tax to pay today, but the least amount of tax for each and every year of retirement that lies ahead. Because once all the tax free cash has been taken, all future income is taxable and this could mean more tax in the long term - particularly if future income is pushed into a higher tax band. So it may make sense to pay some tax now, to reduce the overall tax paid throughout retirement. The individual client age and health will be a dominant factor in this strategy.

Some or all of the personal allowance may also be wasted during the years when just tax free cash is taken. So it would make sense to extract some taxable income - up to the personal allowance at the very minimum. 

Myth 3 - UFPLS gives clients all the flexibility they need.

Contracts which only offer Uncrystallised Funds Pension Lump Sums (UFPLS) will be limited to a fixed ratio of 75:25 income and tax free cash**. When a withdrawal is made, all of it leaves the pension arrangement.

But flexi-access drawdown offers more choice on how benefits can be taken. When funds are designated for drawdown, up to 25% will be tax free and the (crystallised) balance can remain invested in the pension to draw an income from in the future.

This means withdrawals can be;

• all tax free cash;
• all taxable income; or
• a combination of income and tax free cash.

Some modern drawdown contracts are able to take this a step further. Clients are able to take withdrawals which are made up of more than 25% tax free cash, provided their overall tax free cash entitlement isn’t breached. This offers the ability to tailor pension withdrawals to meet clients’ specific needs.

Myth 4 – You can’t take tax free cash after age 75.

Tax free cash can still be taken after age 75, and can therefore continue to support a tax efficient income withdrawal strategy that makes the most of personal allowances and lower tax bands.

The worry is that if a client dies after age 75 before all of their TFC has been taken, an opportunity has been wasted. Ultimately it will be the beneficiaries who are affected - will they be better or worse off?

Obviously it makes sense for all tax free cash to be taken before reaching 75 providing it's going to be spent within a short timescale. But if your client doesn’t plan to do that, the tax free cost of today may be the price of 40% IHT tomorrow.

Death benefits can be paid tax free where death is before age 75. It doesn’t really matter if tax free cash has been taken or not, because the beneficiaries can take the whole fund tax free anyway. But after this age, death benefits will be taxable at the beneficiary’s marginal rate of income tax.

So if the client extracts the tax free cash before age 75 (even though they don't need it for their own purposes) to escape IHT, they must gift it and hope to survive 7 years. And if gifting via a discretionary trust, they must also ensure that they have enough nil rate band if they wish to avoid a lifetime IHT charge. 

Otherwise the comparison is potentially 40% IHT, or an income tax charge on beneficiaries at their own marginal rate of income tax, which may only be 20% for a basic rate taxpayer at current rates.

Myth 5 - You should take tax free cash at the earliest opportunity to avoid LTA charges.

Taking all your tax free cash can help those close to the LTA avoid a LTA tax charge. By taking tax free cash before 75, the remaining pension fund will be smaller as will the growth retested at 75.

But it's important to consider the impact of all tax charges, not just the LTA charge in isolation. What really matters is how much clients have available to them after all taxes have been deducted and how much they can pass to future generations.

Taking tax free cash may reduce the impact of the LTA charge, but it must be remembered that funds will be moved out of the pension wrapper and no longer protected from IHT and tax on investment income and gains.

For some, it may make better financial sense to allow funds to grow in the pension and pay some LTA charge. 

Summary

How and when to take tax free cash will very much depend on an individual’s  circumstances and needs - both current and future. There is no ‘one size fits all’ solution and what's best for particular clients will differ. It's therefore essential that all the consequences of taking tax free cash, or not, are considered before advice can be given, and that your client is in a contract capable of delivering the best mix of tax free cash and income for their needs.

Footnotes:

* Drawdown outstripped annuity purchase by £2.1bn in the first 12 months after the pension freedoms, according to the ABI.
** Clients with protected tax free cash greater than 25% must take all their cash in one go to secure the higher amount.
*** Assumes no fund growth and no change to tax rates, bands or allowances.