A Brief Guide to the Rules Governing Drawdown Pensions:
Executive Summary In July 2012 the government implemented changes to the drawdown pension rules, reducing the income allowance and increasing the tax charge on death for those who die before age 75. The reduction in the income allowance caused uproar and the government have announced that they will move back to the old income limits - although they still haven t confirmed exactly when and how these rules will be reversed. However, a 55% tax-charge will now be levied against vested drawdown plans on death, regardless of age. Serious consideration therefore needs to be given as to how to minimise any tax on death. Attached is a quick summary of the new rules, answering in more detail some frequently asked questions.
The new rules You no longer have to buy an annuity when you reach 75. However, tax of 55% will be deducted from all vested drawdown pensions on the death of the holder and their dependants. In other words, if you have already taken your tax-free cash then a 55% death charge will apply [on that part of the pension where the tax-free cash has been taken], should your dependants remain in drawdown. Where the tax-free cash has NOT been taken in full then any unvested element of the pension can still be passed to beneficiaries tax-free up to the age of 75. However, AFTER THE AGE OF 75 the 55% death charge gets levied on the entire fund including any tax-free cash that hasn t been taken. A surviving spouse can still switch to an annuity or remain in drawdown, but either way, after the policy holder reaches the age of 75 they cannot get at the tax-free cash after his/her death it will be taxed as income thereafter. Furthermore, if the policy holder dies before purchasing an annuity, whilst a surviving spouse can still switch to an annuity, he/she will not be able to buy an annuity with any guaranteed income periods. In this scenario, if they died soon afterwards, the pot would effectively be lost to the insurer through whom the annuity was purchased.
Immediate considerations for those who have NOT yet touched their pensions If you have not yet touched your pension pot and you have been told that you are suffering from a terminal illness [that is likely to get you before you reach 75] then it may be wise to leave the pension pot unvested, as you can pass it on to your beneficiaries tax free. But of course, this does prompt the question - what would then happen if you live beyond 75? In this scenario you could still opt to leave your pension untouched, even past the age of 75. However, in our opinion this would be unwise. Once you ve passed the age of 75, your spouse/beneficiaries cannot take your tax free after your death - your spouse can continue in drawdown, but the tax-free cash would be taxed as income in short, the tax-free cash sum is lost. In short, the only benefit of leaving the tax-free cash after the age of 75 is that it might grow to be a larger fund. In our view the benefit of any potential growth in tax-free cash is outweighed by the risk that your family loses all of the tax-free cash benefit if you die unexpectedly after age 75. In Summary: If you know that you re dying [and death is highly likely to occur before you reach 75], and you haven t touched the pensions, it may be beneficial to leave it well alone. By age 75 you perhaps want to have taken all of your tax-free cash.
Immediate considerations for those who HAVE STARTED taking their drawdown pensions: When the pension holder dies in drawdown their spouse has two options: Stay in Drawdown Buy an Annuity However, a surviving spouse is NOT allowed to add any guarantees to an annuity after the pension holder s death. In short, a surviving spouse can only buy a plain vanilla annuity, which means that when they too die, the pot is lost to the insurer providing the annuity. It may be advisable therefore for the policy holder to buy an annuity with guaranteed income payment periods before they die.
What are the most obvious ways to mitigate the risk of a 55% death tax? If you are facing imminent death, or your health has deteriorated, then you may want to buy an enhanced annuity with guaranteed minimum income periods. But another option may be more enticing to those who wish to remain in drawdown. Given the higher [55%] death charge that now applies, clients may now want to consider eroding their pension pot as quickly as possible. Put simply, if there is less left in the pension pot, you pay less death tax! To get the pot reduced you could start taking an income at a younger age (you are allowed to access your pension from age 55 onwards) If you are not already doing so you could perhaps start taking the maximum income allowance.
A reduction in income rates Whilst it may make sense to draw down pension funds more quickly, sadly many drawdown investors are currently being hit by a double whammy of low interest rates and a reduction in the maximum normal income limit. Combined, this may make it more difficult to take sufficient income to erode the pot quick enough to reduce the potential death tax. Clients could previously take 1.2x the equivalent single life annuity rate as a drawdown income. However, the government has effectively reduced this by 16% - the income is now only 1x the equivalent annuity rate. It would appear as though the government is planning to relent and put the income limit back up to 1.2x the equivalent annuity, but nonetheless, interest rates are likely to remain very low for a while yet. Furthermore, because anything left in the drawdown pension on death gets taxed at 55%, we are finding that many clients would be well advised to start taking the income earlier and at the highest possible rate. Important note: we are not necessarily suggesting that you spend it all, merely that you do get it out of your pension ASAP and over into some other form of savings vehicle where the fund remains accessible.
Flexible Drawdown There was one clear improvement in the rules: For those who can prove a lifetime guaranteed annual income of 20,000 or more, they can now start taking lumps of their private pensions without limit. The removal of the income limits is known as Flexible Drawdown To qualify for Flexible Drawdown you need to provide 20,000 of annual income from three possible sources: Your State Pension And/or any Final Salary Company Pensions in payment Plus any annuity income Immediate considerations 1. Those with larger ex-employer and state pensions may already be able meet the lifetime guaranteed income limit [of 20,000]. 2. Most of our clients won t have a 20,000 state pension &/or employer pension, but those with larger pension funds may want to consider using some of their pension pot to buy an annuity in order to bring them up to the 20,000 limit. Then, once they ve satisfied the 20,000 limit they can go at the fund far more quickly, indeed, without any limit!
Avoiding additional Inheritance Tax Of course there is a risk that if you take the pension income and then move it into another investment vehicle, you could be hit with a double tax-charge. Your pension will be taxed as income when you draw it from your pension, and if you don t then spend the money you may become liable to inheritance tax also in short you d get hit by another 40% bill. Clearly any decision [about taking income early] needs to be well thought out and balanced against any Inheritance Tax considerations. But even if you are wealthy enough to fall into the Inheritance Tax bracket all is not lost - there is a potential solution The gifting of excess income If some or all of your pension income is not needed to maintain your lifestyle then you may want to gift this money on a regular basis to a beneficiary. Why? There is no 7-year rule on gifted excess income, and there are no limits to what you can gift, provided it doesn t decrease your standard of living. Put simply, you can gift excess income and anything that you gift is outside of your estate on day 1 and thus not liable to inheritance tax. Important Note: There are caveats to this possibility beyond the scope of this document and proper advice needs to be sought on this area.
A reduction in gilt yields It is important to note that, as a result of the government pumping vast sums of cash into the markets [through its programme of quantitative easing ], and the use of gilts as a safe haven investment, gilt yields have dropped drastically since 2008. Indeed, whereas the gilt yield would normally be around 4.5%, it is now around 2.5% today. This reduction in gilt yields may cause a double-whammy for those clients who vested before 2008, as their current income allowances will be much higher under the old regime, and may therefore fall when the next review date comes around. This is prompting us to check whether the income that clients are taking can be sustained when the next income review comes up, or whether it will be forced down sadly, if the government don t stop printing cash pretty soon, then we fear the latter!
An improvement in annuity rates and drawdown income levels Whilst we don t pretend that the current reduction is gilts yields isn t a problem, we hope that it will not be all doom and gloom over the longer term put simply, we see this as a short term problem. We have good reason to expect that interest rates (and hence annuity and drawdown rates) will return to more normal levels over the coming years, and we should be able to ask for a review of the drawdown income allowances as this happens. See our Q1, 2012 investment bulletin and look at the yield curve graph and the explanation as to why we expect interest rates to rise by 2015/16.
Switching to an annuity In the main, clients opt to move into drawdown for one of two reasons Retain control over the fund - often as their spouse/dependants have no provisions of their own. To get at tax-free cash without having to take an immediate income We anticipate that few clients will have changed their views on the need to protect the capital for their beneficiaries, but nonetheless, as the death charge is higher for those under age 75, many clients may now wish to consider switching into an annuity as they get older. Indeed, for those reaching 75, it may well be better to buy an annuity with a guaranteed income period, rather than risk dying and losing 55% of the fund in tax. Annuity payments are treated as income and are thus [currently] liable to tax at 20%, 40% or 50% for those earning more than 150k per annum. An annuity can be guaranteed for up to 10 years, and payments are paid into the estate - This will certainly be taxed at a lower rate than the 55% charge. In these uncertain times, this will also eliminate any investment risk, as the annuity income will then be known. But please remember that it is of course entirely possible that annuity rates may rise in the future, and likewise, if your health deteriorates, then it may be possible to obtain an enhanced annuity at a later date, which provides a higher income still.
So to recap Gilt yields are currently very low, and are likely to remain so a little whiles longer. This may cause a sudden drop in the available income for those clients who are coming up to their next income review. The problem has been exacerbated by the new rules the reduction in the drawdown limit from 120% to 100% of the single-life annuity rate. But the new rules do provide greater scope to take the income more quickly by those with larger pension pots those with a guaranteed lifetime pension of 20,000 or more, could be able to draw down the pensions without an annual limit Many clients may now benefit from drawing down their pension at an earlier age, and in larger amounts, in order to reduce their pension pot by the time of death, or they may consider buying an annuity sooner, as here too the income tax rate will be lower than the death tax rate Assuming that they use the gift out of normal expenditure exemption, or gift it and survive 7 years But for those clients that haven t yet fully vested, there is a good reason to pause; please remember that if you die without taking your entire pension, before the age of 75, then the uncrystallised funds can be passed to beneficiaries tax-free.