So, drawdown or annuity? For 20 years, that has been the choice facing retirees. But at least there was a choice – prior to 1995, buying an annuity was pretty much your lot.
Wind the clock forward to April 2015, however, and a bold new era of pension freedoms has begun.
Our pension, we are told, has become as flexible as a bank account.
That said, some pension providers aren’t yet offering the full range of new pension freedoms – and it’s not difficult to see why. Certain aspects of the new freedoms are fiendishly complicated, imposing a hefty administrative and compliance burden.
And that can be a double-edged sword. Because it’s a reasonable bet that anything that imposes a hefty administrative and compliance burden on providers will also be complicated for retirees to figure out, as well.
Important decisions
That isn’t a problem if you’ve got an ever-helpful financial adviser at hand to help out, of course.
Though we all know what bastions of probity these have often proved to be in the past.
So for those of us a little leery of Mercedes-driving gentlemen in flashy fur coats, it might be handy to get some of that complexity demystified, before making potentially irreversible decisions regarding the disposition of our own individual pension savings.
Which is why I thought I’d have a bash at it myself, on behalf of Monevator readers.
Be warned: I’m not a financial industry insider, just an ordinary investor like you.
Please feel free to use the comment box below to amplify (or even correct) what I say if you know better.
Your Lamborghini beckons
Most of the complexity, it seems, comes from the emergence of the new Uncrystallised Funds Pension Lump Sum (UFPLS) route to taking pension benefits.
The phrase is quite a mouthful, and far less memorable than former pensions minister Steve Webb’s oft-quoted remark about the new pension freedoms enabling retirees to spend the lot on a Lamborghini if they so wished.
Nevertheless, if you do want to go down the Lamborghini route, it’s UFPLS that will take you there.
Also, it’s fair to say UFPLS is the route to a great deal many more interesting possibilities besides.
Because it’s UFPLS that really lies at the heart of the new freedoms.
Simply put, apart from UFPLS, there’s not a lot that’s really new, apart from tinkering at the edges – such as removing GAD limits to drawdown, for instance.
So you really do need to get your head around UFPLS, and understand why you might want to go down the UFPLS route – and why you might not.
Crystal clear
The key is the word uncrystallised.
Fairly obviously, a conventional annuity crystallises your pension:
Here’s your pot; here’s your 25% tax-free sum (should you wish to take it); and here’s your regular annuity income.
Likewise, drawdown also crystallises your pension – although rather less so, now that GAD withdrawal rates are a thing of the past:
Here’s your pot, here’s your 25% tax-free sum (should you wish to take it); and here’s your resulting drawdown income—which can be regular, irregular, or deferred, as you wish.
(Why would you elect for drawdown, and yet defer the resulting income? To get your hands on the 25% tax-free sum, of course.)
In contrast, UFPLS, as the name makes clear, does not crystallise your pension.
Making a withdrawal crystallises only the amount that is being withdrawn – leaving the remainder invested to (hopefully) continue growing.
The retiree can take the 25% tax-free sum each and every time they make such a withdrawal, with the remainder of the withdrawn amount subject to tax at the retiree’s highest marginal rate.
As a result, UFPLS offers the prospect of giving retirees a larger amount of tax-free cash than is possible with conventional drawdown, because the sum remaining invested (hopefully) continues to grow – and 25% of a larger amount is, er, a larger amount.
To UFPLS or not?
So should we all opt for UFPLS?
According to pension experts such as Tom McPhail at Hargreaves Lansdown, UFPLS is a decision requiring careful thought.
Not least because conventional drawdown offers two distinct advantages over UFPLS.
First, because of its administrative overhead (read: ‘form filling’), UFPLS is better regarded as a vehicle for irregular (and perhaps sizeable) withdrawals.
For a monthly income, drawdown is going to be an easier route.
Second, with UFPLS the government has taken the opportunity to clamp down on allowance ‘recycling’ – the dodge where investors took out the 25% tax-free sum and re-invested it their pension, thereby getting a double-dollop of tax relief.
Or, as we Northerners say, ‘free money’.
This clampdown takes the form of a £10,000 annual Money Purchase Annual Allowance, coupled to making post-UFPLS pension savings ineligible for the sometimes-handy ‘Carry Forward’ rules, whereby earnings in one tax year can be used to gain tax relief in another tax year.
So in a post-UFPLS situation, if one were to, say, sell a business or benefit from a large inheritance, you couldn’t tuck the money inside your pension in handy £40,000 dollops, gaining tax relief each time.
In contrast, investors simply taking the 25% tax-free sum through the drawdown route will not be deemed to have used the new pension freedoms, and so retain their ability to benefit from the £40,000 tax relief allowance.
(Don’t take income, though – otherwise the £40,000 tax allowance will be lost.)
The bottom line
So there we have it. Lots of things to weigh up, and various calculations to perform.
From what I can make of it, three ‘golden rules’ seem to apply:
- Despite the allure of the Lamborghini, large UFPLS withdrawals are best avoided, as the tax ‘hit’ will be too expensive.
- Don’t opt for UFPLS if you think you’ll subsequently have a sizeable lump sum to invest—in short, UFPLS is for genuine, ‘don’t look back’ deaccumulators.
- If you need ready cash in the form of a sizeable lump sum, then taking the 25% tax-free cash via drawdown leaves more options open than taking the equivalent sum out via UFPLS.
Note: Do you know all about UFPLS? We’d love to hear from you below. And do read The Greybeard’s other articles on deaccumulation and the changing landscape for pensions.
Sorry, but I didn’t find that at all clear, perhaps this worked example shows how I understand it
If you start with a £1m pot, you might adopt the following strategy each year to be tax efficient, assuming you need £30k to live, and to make numbers simple, personal allowance is £15k, higher rate tax starts at £45k and basic tax is 20%. I assume no other savings
Crystalise £60k and withdraw it all, only paying basic rate tax. Spend £30k, put £15k in an ISA, pay £6k in tax ((45k-15k)*0.2) invest the remaining £9k in 2% dividend shares
Repeat every year until the shares are worth £250k, when their dividend income has used up the £5k allowance, and starts affecting your main tax allowance. Remember to shuffle the shares occasionally to avoid CGT.
Withdraw less if you have other income, like a state or occupational pension or paper-round.
This might take 25 years to empty the pension, after which you live on state pension, ISA and share portfolio
This drains the pension fairly optimally. Withdrawing a bit less would allow you to use the gap between personal allowance and state pension later on if you expect no other taxable income then.
I don’t see the point of leaving money in drawdown in a pension when it could be in an ISA. Pay the tax now and avoid paying tax on any future capital gains/reinvested dividends.
* numbers chosen to make calculations easy
I found it clear and useful. Particularly the explanation of drawdown. I generally understood the ufpls rules, but was not aware of the nuances of drawdown and it being such a significantly different product.
Thanks. Good article.
UFPLS is simply a renaming of the ability of someone to allocate only part of their funds to (flexi-access) drawdown and then take that allocated amount as cash (with 25% tax free) with the amount not allocated remaining invested. So the UFPLS outcome is achievable through drawdown. While the legislators could have chosen a better acronym to use it does have some use in making it easier for providers to allow simple options for people to flexibly access their pensions through UFPLS, in situations where providers don’t want to offer the full drawdown options.
However I think we are talking here about whether to 1) put all the funds into drawdown, taking the 25% cash and possible a bit more immediately vs 2) taking a UFPLS. So the following is based on this:
From a tax perspective, for someone who is normally going to be a basic rate taxpayer in retirement (say), the key to accessing your pension in the most tax efficient way is based on two key principles
a) make sure you use your personal allowance each year and
b) make sure you don’t slip into higher rate tax in any year by taking too much out.
As long as you follow these rules it really doesn’t matter when you take the 25% tax free element of your pension.
Using UFPLS lump sums can be a good idea if you have retired early and have a couple of years before your main retirement income kicks in, for example if you have state pension and defined benefit pensions payable later. By using UFPLS , rather than taking all of your 25% tax free cash up front through drawdown it is easier to use up your personal allowance to meet principle a).
On the other hand if you need a sizeable cash lump sum at the beginning of your retirement then using drawdown can be a good idea to meet principle b).
The article says ‘As a result, UFPLS offers the prospect of giving retirees a larger amount of tax-free cash than is possible with conventional drawdown, because the sum remaining invested (hopefully) continues to grow – and 25% of a larger amount is, er, a larger amount.’
That statement while true overlooks the important point that you pay the tax earlier under the UFPLS route if taking an identical net amount each year, so although you pay less tax under UFPLS overall (which is roughly equivalent to the statement you get a larger amount of tax free cash), the fact that you have to pay the tax earlier exactly balances out the advantage of the lower tax (or equivalently higher tax free cash). That assumes the money taken out of the pension is either spent to cover expenditure, and/or put into a tax free investment such an ISA (and we are assuming principles 1 and 2 are not violated here). It is only if money is taken out, not required and and put into a taxed savings/investment vehicle that the article statement has some relevance. However the issue then is that the person has taken money out of their pension that they didn’t need or couldn’t save/invest tax efficiently, not that they chose the wrong route tax wise to take it out.
So there is no income tax reason to prefer UFPLS over drawdown unless it helps you to avoid violating principles a) and b). It is a common myth that UFPLS is more tax efficient simply because you get more tax free cash because of the growth, that a lot of the financial services industry gets wrong. It’s hard to explain in words so crunch some numbers if you don’t believe me.
Incidentally in terms of accessing the freedoms there are two recycling restrictions that apply. One is the MPAA mentioned in the article. The other is the restriction on not recycling more than £7,500 of tax free cash back into a pension in order to increase payments into one or more pension plans to gain more tax relief (the precise rules are very complicated).
@Greybeard
“So in a post-UFPLS situation, if one were to, say, sell a business or benefit from a large inheritance, you couldn’t tuck the money inside your pension in handy £40,000 dollops, gaining tax relief each time.”
I’m struggling to see how this works?
So I’m retired and I’m drawing my pension having crystalised the whole pension
I already have a big 25% tax free lump sum to hand and then I get a whole lot more from an inheritance, say. Lucky me
I’ve retired so I don’t have any earnings from employment. This is how HMRC defines earnings in simple terms on gov.uk: “Meaning of earnings – for tax purposes, the word earnings in relation to an office or employment means: any salary, wages or fee; any gratuity or other profit or incidental benefit of any kind obtained by the employee if it is money or money’s worth; anything else that constitutes an emolument of the employment. This is a wide definition. The second and third bullets ensure that all money payments that are similar to salaries, fees and wages are taxed as earnings. Examples are bonuses, commissions, tips, overtime pay and extra money earnings of any kind.”
How could I stick £40,000 into my pension when I don’t have any earnings to get tax relief against?
@Neverland,
Of course you will have earnings in that scenario. Your pension drawdown withdrawals are your earnings, and you will be liable for tax on them. So those are the earnings that you will get tax relief on.
There are so many considerations wholly dependant on each individuals circumstances to take into account when it comes to finance, it makes the writing of a simple guide almost impossible given the quantity of caveats required to depersonalise it, to the extent it would probably overshadow the actual advice.
I’d say speak to a financial adviser but the negative connotations that always invokes immediately causes me to pause.
The only advice I would freely give without fear of contradiction would be to draw sufficient funds from your pension by whatever mechanism to ensure you maximise all benefits by whatever reason including but not limited to tax planning, whilst always remembering to factor in the effect of NOT making a withdrawal when considering any withdrawal.
A couple of things spring to mind when looking at John’s worked example in comment No1 though: –
i) The IHT planning opportunity a pension fund provides shouldn’t be discounted.
ii) There’s unnecessary payment of income tax by not investing £4,500.oo (30% of the £15k tax free sum thus avoiding HMRC recycling rules {assuming that the £4.5k doesn’t represent an increase in pension contributions invested in previous 5 year period – unlikely given £1M pension pot}) into a new pension scheme for the 2% dividend paying shares?
Other than that, it’s a perfectly reasonable strategy assuming you have no heirs or perhaps have no intention of leaving them anything – although that can be changed at will by the judiciary 🙂
I tend to think of just three descriptors when referring to pension income, those being Flexible drawdown, Capped drawdown & Annuity.
Obviously Flexible being the new UFPLS method of drawdown, Capped being the old GAD limited method and Annuity being what it always was. Oh and to bastardise an old favourite from the 70’s, flexibility isn’t always your friend, whether pension or credit card!
Good article as always TA/TI
@Greybeard
Are you sure, I am looking at gov.uk, not the primary legislation but:
On pension tax relief it says: “You can get tax relief on private pension contributions worth up to 100% of your annual earnings”
Definition of earnings it says: “the word earnings means: any salary, wages or fee; any gratuity or other profit or incidental benefit if it is money or money’s worth; anything else that constitutes an emolument of the employment.”
@Neverland,
Take it from me: your pension is taxed! And therefore, tax relief is obtainable against that tax.
See: https://www.gov.uk/tax-on-pension
@Greybeard
I think you are incorrect, the link you have given is a definition of income which is subject to tax of which earnings are just one component
However pension tax relief is given on earnings, which relate to an employment
Its been several years since I was last able to make pension contributions (LTA), but when I made these out of our company they paid direct from the company, not from the company dividend income
My understanding of the way capped drawdown used to work for the PAYE crowd is:
– crystalise the pension at 55, take the tax free lump sum
– don’t take a pension income
– keep working and make contributions to the pension, notionally from earnings from employment
@Greybeard
I think the page you want for relevant earnings is:
http://www.hmrc.gov.uk/manuals/rpsmmanual/rpsm05101150.htm
and pension income doesn’t count.
The key factor in respect of the recycling rules is they’re applied in the year a tax free lump is taken, the 2 years before and the 2 years after. That’s one of the problems with UFPLS, you’re forever receiving tax free lumps so falling under the scope of recycling rules.
If you have sufficient funds (pension income included) to make a relievable pension contribution, if it’s 3 or more years after taking the tax free sum HMRC will not have an issue.
Also, and this may specifically be of use to you Neverland if that elusive butterfly of an inheritance windfall wings your way 🙂 it’s from the technical pages of the HMRC manual used to give advice to their inspectors: –
Example 8 – An inheritance
A member takes a pension commencement lump sum. Soon after, the member’s uncle dies, leaving the member an inheritance. Because of the unexpected inheritance (and not because of the pension commencement lump sum), the member decides to make a one-off contribution into a registered pension scheme of the amount of the inheritance (or less). That contribution will not trigger the recycling rule because the member did not pre-plan to use the pension commencement lump sum as a means to pay significantly greater contributions into the registered pension scheme.
I’m afraid Greybeard that’s incorrect. It must be relevant UK earnings in order to attract tax relief, pension income does not count as relevant UK earnings. See the last point here http://www.hmrc.gov.uk/manuals/rpsmmanual/rpsm05200060.htm
@John B the fact that your pension pot is not included within your assets for inheritance tax purposes and there is no longer a tax charge on death is a very big reason for many people to keep their assets within the pension wrapper.
Hmm. Looks like you’re right: “For the avoidance of doubt a pension is not classed as earnings and cannot be included in the definition of relevant UK earnings.”
I’ve learned something there. Thank you both.
@Monk
You say:
“If you have sufficient funds (pension income included) to make a relievable pension contribution, if it’s 3 or more years after taking the tax free sum HMRC will not have an issue.”
Why would you want to take an income from a pension in capped drawdown just to…put it back into your pension?
I can see how that might work if had an income below the income tax threshold (£12,000 or whatever), with the automatic top up on pension contributions, but otherwise it just looks like money going round in a circle
Hmm indeed, throws my financial planning overboard – so I guess it’s back to the drawing board.
I could always use the UK resident reason I suppose and contribute £3,600.00 (less basic rate tax) into a pension, I am afterall some way off the aged 75 cut off…
It never ceases to amaze me the wealth of knowledge these pages and posters freely provide, thanks one and all 🙂
It would purely be for IHT reasons Neverland, the taxation of funds in drawdown are different to funds that are not. I will of course have to revise my position when/if I reach 75
Fourth ‘golden rule’ — don’t use UFPLS if you hit the lifetime allowance. At that point you’re leaving future growth exposed to a 25%/55% LTA tax surcharge.
@Mumble
Forgive me for being a bit thick, but is that because you get tested against the LTA each time you make an uncrystallised funds lump sum pension withdrawel?
@Monk “….. the wealth of knowledge these pages and posters freely provide …..”
Beyond price!
Surely a massive advantage of taking the maximum 25% of the entire pot (over doing it gradually through UFPLS) as soon as you hit 55, whether or not you defer drawdown, is that you then remove the risk of government abolishing or capping the 25% lump sum? Do fellow Captain Paranoias agree?
@SemiPassive
I think you have to make the decisions on the rules as they stand. Excessive paranoia is probably not going to benefit you.
You assume that the Government will remove tax benefits from pensions. Alternatively they might leave pensions as they are, or make them more attractive, (which has generally been the case so far) or introduce a wealth tax on funds outside of pensions.
I have to say this post and comments are a good argument for further pension simplification. If the Monevator audience and author have difficulty understanding, then I pity the average / below average person trying to get their head around this.
The case for withdrawing money from a pension PDQ is fear of (i) the TFLS being reduced, and (ii) the basic rate of income tax being increased. I’m not too worried about (i) but think it likely that (ii) will happen during my widow’s life.
A case for leaving money in the pension tax-shelter is based on (iii) as Greybeard said, the chance of getting an increased TFLS because of investment growth, and (iv) the IHT advantages – which may well prove temporary.
But you can always split your bets.
“the IHT advantages” would have been better phrased as “the inheritance advantages”, since they include a lovely deal for the widow if the pensioner should die before 75.
Quick follow up. I’ve gone back to my sources, and yes, as @Monk has explained, inheritances are OK: you *do* get tax relief on those. Has anyone seen anything on the proceeds of sales of businesses? That bit I’m struggling to stand up.
Anyone considering any sort of drawdown from their pension should make sure they fully understand the intricacies of the current rules. It gets more complicated still if someone also has one or more defined benefit pensions as well as a personal pension.
The benefits of partial crystallisation, e.g. using multiple UFPLS withdrawals are 1) this optimises the amount of tax free cash and 2) it optimises the amount left in the pension (and so outside your estate and free of IHT). The potential disadvantage is that you may run into lifetime allowance problems.
Anyone with a moderately large pension pot should beware of the potential lifetime allowance traps that are waiting for them when they reach 75. UFPLSs were not available when I crystallised my pension, but even if they were, they would have been useless to me. I fully crystallised my pension when I was 55. This was necessary as even modest growth was likely to push me over the LTA limit by my 75th birthday unless I took action to reduce the size of the pension pot at the earliest opportunity. I had the idea of crystallising a bit of my pension each year so as to maximise the tax free cash, but once I modelled this in a spreadsheet I could see that I was likely to run into an LTA problem that way. I would suggest that anyone with a 6-7 figure pension pot should model their expected UFPLS withdrawals to see if they could also be heading for a frustrating 75th birthday. Traditional full crystallisation may be a better route to take, even if a large amount of tax free cash causes other tax headaches (you could always spend it or give it away!).
Never, since winning a place at a sarf London grammar skool have I realised quite how far on the wrong side of the tracks I was born 😉
No grammar schools where I grew up, just comprehensives. Nevertheless, my school did teach me how to spell.
@Naeclue, Ermine
I will unavoidably (apart from, say, emigrating) have to pay some sort of lifetime allowance charge at 55 and maybe again at 75, but the fact is that you have to acknowledge that it is a very nice problem to have #firstworldproblems
“I will unavoidably (apart from, say, emigrating) have to pay some sort of lifetime allowance charge at 55”.
Cheer up; maybe a huge market crash will spare you that fate. Unless you are entirely in DB schemes, of course.
Well the one way to escape lifetime allowances is to get yourself on an MP’s pension.
They have a final salary scheme, 1/40ths
Anyone working there for 30 years would get a pension of £55k per annum if my maths is correct.
At current annuity rates, that’s likely to cost in excess of £1.4 million.
These are the same people voting in caps and cuts for the rest of us.
@Jeff
What makes you think MPs’ pensions are exempt from the rules about annual and lifetime allowances?
Thanks for the great article GreyBeard, and to all those who have commented. The comments highlight the complexity of the UFPLS product and the necessity for those new to the investment world to get financial advice before going down the UFPLS route.
I have referenced the article in http://www.theukpensionsblog.co.uk as this is just the sort of information that those considering managing their own pension should read and reflect upon.
Tyro
MPs get one of those gold plated final salary pensions. So their money is not actually held as a lump sum. Therefore getting around the lifetime allowance.
However the value of their pension significantly exceeds anything us poor taxpayers would expect to earn from something within the lifetime allowance.
If they cut the lifetime allowance for us, why do they not cut their own maximum pensions to a level consistent with the annuity that might be had from the lifetime allowance?
Your ire towards MP’s is undoubtably justified Jeff, but even their proceeds of crime is subject to the same HMRC limits we ‘enjoy’ if this source is true http://www.mypcpfpension.co.uk
Judges do get some sort of special 10 year transitional exemption from the scheme the hoi polloi have to endure, a decision reached if I recall correctly, on the hard and wonderful work they do…!
There were calls for a judicial enquiry into the decision by some of the more fiscally unaware amongst the general population, not realising that i) it would have been headed up by a senior judge and ii) it’s cheaper just to pay the old ‘fools’ and avoid the cost of an enquiry.
If only the rest of us worked as hard and as wonderful as those ermin clad wig wearers
@Jeff – just because it’s a final salary pension doesn’t mean the lifetime and annual allowances don’t apply. I too have a final salary pension and it definitely does fall under the same rules, so my pension contributions each year have to keep within the annual allowance limits and I also have to observe the lifetime allowance limits. It’s true that it’s not as clear to see how much has been contributed in a year with a defined benefit pension as it is with a money purchase scheme, but that just means we have to grapple with a complicated calculation each year in order to work it out. No doubt there’s lots to criticise about MPs’ pensions, but you have just jumped to the conclusion that because they’re final salary they must be exempt from the rules, without checking your facts. Maybe they are, maybe they aren’t. I don’t know for certain, and nor, it seems, do you. But is seems pretty unlikely on the face of it.