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Phasing Retirement

This article explains the tax benefits associated with phasing retirement income.

For many “retirement” as a word may in the past have summarised the lifestyle expectations of those who were approaching it. Compare that with today. The age from which state retirement benefits are paid is increasing and will continue to do so, and we are living longer.

The statistics also show that, whether through necessity or wish, there is a growing trend for people to continue working in some form after their state pension age. The Office of National Statistics ‘Labour Market Statistics’ confirmed that the employment rate for those aged 65 and over is 9.5% and increasing, having reached 1 million individuals in work for the first time. More people are easing into retirement gradually, and to support this many will take a phased approach to their retirement income.

Phasing pension income over time has clear tax advantages. Crystallising just enough to provide the individual with the pension income they want, leaving the remainder of their funds in uncrystallised status. This is important because any lump sums on death from uncrystallised rights before age 75 are paid tax free. A lump sum death benefit from any remaining crystallised funds is subject to a 55% tax charge.

Drawdown

Drawdown enables an individual to call upon their retirement savings at any time. Disinvesting only what is needed is highly attractive. But investors do need to be aware of the overall tax implications associated with different income withdrawal strategies and this includes the taxation position on lump sum death benefits.

Is using a pension commencement lump sum to provide for an individual’s income needs tax advantageous? At first glance it seems tax efficient as no tax is due on the additional income. However, to get a complete picture you need to consider all types of tax, including those following death. Consider the following example.

Example

Ian has an uncrystallised fund worth £350,000. He wishes to top up his income by £8,000 net a year. If Ian opted for phased drawdown using the pension commencement lump sum under capped drawdown to provide the extra £8k, the position would be as follows if he died after 5 years.

(Ian is a basic rate taxpayer. For simplicity the calculations assume there is no investment growth and the gilt rate remains at 2.5% over the period. This calculation is based on phasing income as an additional designation into the same policy).

 

 Phase using PCLS to provide  income in capped drawdown

 Phase using PCLS and maximum  income under capped drawdown

 Remaining  uncrystallised fund  after 5 years

 £190,000

 £244,462

 Funds in drawdown  after 5 years

 £120,000

 £62,134

 Lump sum death  benefit

 £190,000 uncrystallised funds
 +
 £120,000 less 55% tax
 Total lump sum = £244,000

 £244,462 uncrystallised funds
 +
 £62,134 less 55% tax
 Total lump sum = £272,422.30

 Total tax liability

 £66,000 (18.85%)

 £3,403.87 income tax
 £34,173.70 (55% lump sum death  benefit tax) 
 Total tax paid = £37,577.57


Clearly phasing retirement income, by taking a mixture of tax-free cash and income withdrawals, results in a better outcome.

If Ian were able to qualify for Flexible Drawdown the position is further improved. The following table compares the position after 5 years between capped and flexible drawdown (i.e. taking the whole of the crystallised fund as income each year rather than leaving the funds in capped drawdown).

  

 Phase using PCLS and maximum  income under capped drawdown

 Flexible Drawdown

 Remaining  uncrystallised fund  after 5 years

 £244,462

 £302,940

 Funds in drawdown  after 5 years

 £62,134

 £0

 Lump sum death benefit

 £244,462 uncrystallised funds
 +
 £62,134 less 55% tax 
 Total lump sum = £272,422.30

 £302,940 uncrystallised funds

 Total tax liability 

 £3,403.87 income tax
 £34,173.70 (55% lump sum death  benefit tax)
 Total tax paid = £37,577.57

 £7059
 (2%) reflects income tax on  income payments received

 

Flexible drawdown is more efficient than capped drawdown since Ian is able to crystallise just enough to provide the income he requires leaving the remainder of his funds in uncrystallised status.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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