More or less unrestricted access to pension pots in retirement is already tempting people to take the money and run. And next year, when the full flexible regime is in place, the trickle of encashments could turn into a flood.
Whether to take the money, how much to take and when will be the stuff of many discussions. There are still a few unknowns – not least the tax rate that would apply on death – but what should be the basic principles and ground rules? It is not too early to start thinking through some of the options.
Circumstances alter cases. A client still in the accumulation phase is in a different position from the person who needs to start spending some of their savings now. There are some awkward transition periods between saving and spending. Also, someone at the cusp of their lifetime allowance differs from someone well within its limits. Non-taxpayers should probably make tax-free withdrawals while they can.
The default position is to keep the money in the pension and draw income only when needed. The big and simple point to get across is that clients will almost certainly pay income tax if they take non-lump sum income out of their pension. But if they keep it in the pension, it will grow, more or less tax-free.
So the sheer movement of money out of the pension outside the lump sum will lead to tax on the whole amount. This differs from most other investments where just the interest or dividends are subject to income tax. Even if there is capital gains tax to pay, it will be only on the gain, not the total capital value.
Tax implications of withdrawals
Drawing the income from a pension makes sense if the client needs to spend it but probably not if they intend to reinvest the income into most other types of asset.
If, for example, a client draws £10,000 gross from her pension, she will receive just £8,000 assuming she is a basic rate taxpayer. If she is thinking of investing the £8,000, she would probably be better off leaving the £10,000 in the pension scheme with the extra £2,000 available to generate more income and growth.
For a higher- or additional-rate taxpayer, the position is even starker. Drawing money out of a pension to make a reinvestment in an Isa or property or other asset would be drastically less tax-efficient – at least in principle.
A key skill for advisers is the ability to carry out rapid income tax computations. The aim is to help clients understand the tax they will have to pay on different levels of withdrawal and how it is often wise to spread it.
Even deciding whether to take the PCLS and reinvest it outside the pension should give pause for thought. Up to the effective limit of the lifetime allowance, the PCLS will grow more or less free of tax on the reinvested income and capital gains. That would happen within an Isa without a tax charge on the proceeds but there is not much else that would be so tax advantaged.
Why withdraw funds?
So what may make it worth taking money out of the pension for some investment? One reason may be to make gifts to mitigate inheritance tax, which may include putting money into an investment that would qualify for IHT business assets relief.
But it will not be possible to assess this option until we know the death rates that will apply to pension funds and we will not know the Government’s proposals for this until the Autumn Statement. The tax position on death is a big issue because it could be a major determinant of the best strategy to follow.
Other factors include the relative costs of keeping funds in a pension and holding them in other types of investment. In most cases, the differences seem unlikely to be large enough to justify shifting out of the pension regime. It would almost certainly be preferable to move pension providers rather than invest outside the registered pension regime to save admin costs.
A client may be attracted to investments that cannot be held in a registered pension arrangement although this is a pretty restricted field. Highly exotic investments that no sane Sipp provider would now permit could be one category.
The most likely would be residential property. But in practical terms the amount of cash a client would need to withdraw from the pension to make an investment would trigger such a huge tax bill that even the most property-obsessed investor would probably see sense.
So the basic rule for now, at least, is to keep the money in the pension.
Danby Bloch is editorial director of Taxbriefs Financial Publishing
This article originally appeared in Money Marketing