Pensions freedom: go steady

Home imageThe new pensions freedom rules are very useful for people in retirement – providing lots more flexibility – but there are dangers if you draw funds without thinking through the possible tax consequences.

Since 6 April 2015, it has been possible for you to draw a large lump sum from your pension scheme to spend on whatever you like, providing you are aged 55 or over. Pensions freedom could allow you to pay off your debts, go on a world cruise or carry out home improvements, or you may wish to help your children or grandchildren through school or university or fund a deposit for their first home.

But beware, you might receive a lot less from your pensions than you expect. Many people think all pension lump sum payments are tax free. Some are but many are not and you may find the tax deduction is far bigger than you think.

There are two ways in which you can flexibly draw from your pension fund. Flexi-access drawdown lets you take a tax-free lump sum, usually 25% of your fund, and leave the rest invested. Withdrawals from the remaining 75% are then taxable in full. If instead payments are made under the uncrystallised funds pension lump sum (UFPLS) rules, each payment consists of 25% tax-free cash with the rest taxable. There are other differences between flexi-access drawdown and UFPLS, notably that UFPLS is likely eventually to result in a greater amount of tax-free cash.

When a taxable payment is made, the tax is calculated under pay as you earn (PAYE) using an emergency ‘month 1’ tax code. That means only one twelfth of the personal allowance and each tax band is set against the payment, resulting in more of it being taxable at higher rates. For example, if you take a payment of £40,000 under UFPLS, £30,000 will be taxable and tax of £11,947 will be deducted.

But if that payment is your only income in 2015/16, your correct tax liability would be £3,880. To reclaim the overpayment of £8,067, you have to go to HM Revenue & Customs, leaving you out of pocket while it is processed.

If you are planning to make pension withdrawals, it is essential to take professional advice both on the choice of arrangement and on your potential immediate and final tax liabilities.