Answered by Stephen Moore
Staying one step ahead of the tax man
While there’s no difference between the tax liability that attaches to an income drawn from a final salary pension and the income from a defined contribution (money purchase) pension, the far greater flexibility that comes from a defined contribution arrangement means that it presents numerous opportunities for you to reduce your tax liabilities in retirement.
In essence, after you’ve taken any tax-free cash that might be available to you, a final salary pension will pay a guaranteed level of income, that’s likely be index linked, for the remainder of your life.
If the level of that income, or its subsequent indexation, puts you into the 40% tax bracket then you’ll be paying 40% tax throughout your retirement.
By moving to a defined contribution arrangement you can opt to phase your pension pot into what’s now known as pension drawdown. This provides complete control of the way in which you access your benefits allowing you to take either lump sums, or a regular income, or a combination of the two.
This means that you have the option to set your income below your highest marginal rate for income tax and so pay less tax. Meanwhile, a well managed programme of tax-free lump sum withdrawals can be used to increase the total pension benefits you draw each year but without increasing your taxable income.
By moving to a defined contribution arrangement and taking a phased approach to flexi-access drawdown, your pension pot also remains invested and can continue to grow in the tax-efficient environment of your chosen pension ‘wrapper’.
You can even continue to contribute up to £4,000 a year to your drawdown pension (receiving tax relief at your marginal rate) after you’ve begun to take your benefits. It goes without saying that neither of these options is available to those with final salary pensions.
The ‘drawdown drawback’
The other big drawback with final salary benefits is that while they frequently include a reduced (50%) widow’s pension, once you and your spouse have died the value of any remaining pension benefits is lost. This means that they can represent poor value for those who don’t happen to enjoy a long retirement.
By contrast, transferring your final salary benefits to a money purchase arrangement will transform them into a major financial asset that can provide both income and tax-efficient lump sums in retirement with the remaining pension wealth passed to your beneficiaries free of inheritance tax and, assuming you die before age 75 free of any income tax liability.
They can choose to continue drawdown – a process called nominee drawdown –and enjoy the income tax free or they can purchase an annuity, the income from which will also be free of tax.
Currently, if you die after age 75, your beneficiaries will be liable to income tax at their marginal rate on anything you might leave them. This means they’ll pay tax on any subsequent drawdown or annuity income.
The rules surrounding your lifetime allowance for pension savings of £1 million are complex and quite different for members of final salary schemes than for those in defined contribution pensions.
However, the greater flexibility of the latter means that there are numerous options for members of defined contribution schemes when it comes to minimising the additional tax liabilities that might attach to their pension pot if it grows past the current £1 million lifetime allowance.
One of the abiding attractions of a pension transfer – whether you have money purchase or final salary arrangements – is the opportunity to bring all your pension savings together into one easy to manage portfolio with one set of reporting. This also makes managing your tax bill far less arduous.
How your income is taxed in retirement
When the times comes, any income you draw from your pension pot will be subject to income tax at your marginal rate, which will be deducted at source by either your employer’s scheme or your drawdown provider. It will be added to the other income you receive each tax year, including the state pension and any earnings from employment, dividends, rental income or your savings. The first part of your income will be covered by that tax year’s personal allowance; after that any subsequent income is taxed at your marginal rate.
The flexibility to manage your pension income as you see fit means that flexi-access drawdown brings with it the responsibility to monitor your withdrawal levels carefully or risk unintended tax bills or the depletion of your pension pot.
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