The post-Budget pension drawdown regime means advisers will have to become pretty slick at income tax computations. Income tax will be a key factor for deciding how much clients should draw down from their pensions in any particular year.
Clients will soon have unprecedented simple access to their pension funds from the age of 55 and advisers will be in a unique position to save them from various tax disasters.
The temptation for many clients will be to draw out as much money as possible as quickly as possible – with the danger that they could be trapped into paying more income tax than necessary. Some clients who have never got to grips with the principles and mechanics of income tax may be completely flummoxed by the whole process.
Even in the interim period of the current tax year, many more people will be able to get their hands on all of their pension savings – or at least relatively large amounts. For example, there will be those who now have enough secure income to take flexible drawdown, especially following the reduction in the minimum income guarantee to £12,000 a year.
From April 2015 there will be more or less a free-for-all in terms of access to pension funds if the new rules go through as expected. But all that extra taxable income could land clients with a large and surprising tax bill. Some people will need protecting from themselves – or at least from their poor understanding of the tax system.
If you have not bothered much with the niceties of income tax computations, prepare to master the art and become skilled at providing clients with clear explanations.
The most common danger is higher-rate income tax. “Fiscal drag” has pulled over 4 million taxpayers into the 40% tax zone. That is the process of failing to adjust allowances and thresholds enough to keep up with rising incomes. In recent years, the threshold has even moved downwards.
Someone who has never paid 40% income tax may have no inkling that adding several thousands of pounds to their income for a year may mean they will receive a tax demand after the end of the year – when it will be too late to do much about it.
At the most basic level, an adviser could explain how spreading the encashment of their pension fund over several years could make all the difference and keep them safely in the basic rate tax band.
There are other traps to consider:
- The potential loss of age allowance for some people, although there is now very little difference between the age allowance and the ordinary personal allowance; the extra tax at stake this year is therefore probably only around £100
- For someone whose pension encashment could push them into an income bracket above £100,000, the consequent loss of all or some of their personal allowance for the year could be a lot more painful
- Not many people nearing retirement receive child benefit but some grandparents and others can qualify if they are carers of young children. A sudden increase in pension income could cause them to lose all or part of their child benefit entitlement for the year
- If an investor decided to realise a capital gain or encash a life assurance bond in the same year as their big pension encashment, they may find themselves with a hefty tax bill on the profit.
A basic principle to grasp is the rule about the priorities for taxing income (and gains). A person’s earned income includes their pension and this is taxed first, so it is set against their reliefs and allowances before it is set against their other income and gains. Even if the extra pension income is not taxed at more than the basic rate, it can push other income and gains into higher rates.
A nasty surprise awaits the client who has been living happily off dividend income within the basic rate band for some time and has therefore been paying no further tax on it. More earnings in terms of a one-off dollop of pension income could push this dividend income into the higher-rate tax band and trigger a tax charge of another 25%.
But it may be avoided with a bit of good advice.
Danby Bloch is editorial director at Taxbriefs