Post A-Day Pension Quirks - Tax-Free Cash, or Increased Pension?
Well, this is a bit of a funny one. Iíve been thinking about the strange things that weíll be able to do with our pensions from A-Day (6 April 2006) and how they can combine in interesting ways. They interest me anyway and for all I know Iím a normal person, so they may interest you too.
After A-Day people in occupational money-purchase schemes (where those occupational schemes are altered to reflect the new rules), will no longer have to leave service and retire to get hold of their tax-free cash. At the moment, the only way to get your grubby mitts on your tax-free cash entitlement from these schemes once youíre over 50 is to retire and start drawing an income from your pension savings too. If you have a Personal or Stakeholder pension, whilst you can take tax-free cash without having to leave service and retire, there is still a requirement to set up some sort of income when the tax-free cash payment is made.
For people in their early fifties thatís rarely a good idea because the lower level of pension you get at that age means youíre likely to be giving up too much just to get hold of your cash. Nevertheless, plenty of people have gone ahead and done it anyway with their deferred pensions and itís not too hard to see why the ability to get tax-free cash is so compelling.
One of the big changes on A-Day will be that it will be possible for people of 50 or over who are active members of money-purchase schemes (whether occupational or personal) to Ďdesignateí all or some of their pension fund as ĎUnsecured Pensioní while they still carry on accruing future benefits as members of the scheme. This is the new form of something we currently call ĎIncome Drawdowní, but under the new rules there will be no need to draw down any income from the Unsecured Pension Fund. You can just leave it to continue growing alongside the rest of your fund, but you can take the tax-free cash out even though youíve decided not to draw an income. Thatís really good I think and it will make pensions much more useful all round.
The tax-free cash will no longer be called tax-free cash after A-Day, by the way. It is being renamed as the Pension Commencement Lump Sum (or PCLS), apparently so it will more properly reflect what it is. Itís a tax-free lump sum you get on pension commencement, but perversely, as I just said, you donít have to have your pension commence to get it. I prefer the term tax-free cash myself and see all this PCLS name change nonsense as change for the sake of change, but weíll have to get used to it as it will soon become part of the almost unfathomable language that is the only one that most pension practitioners seem to be able to understand. If you want to talk to them, you can only really do it on their terms, so youíll need to understand what their new words will mean.
The PCLS will at least be easy to work out. It is simply one third of the amount of the pension fund that is designated as Unsecured Pension. So, if someone aged 50 designates that £75,000 of their total fund of £100,000 is to be set aside as Unsecured Income, then the tax-free Pension Commencement Lump Sum they are allowed to draw will be £25,000. I should point out here that after 2010 this wonít be available to people between 50 and 55 as the minimum age at which people can take retirement benefits is increasing to age 55 in that year. But for a while after A-Day at least it will still be possible to retire from age 50. But people setting aside some or all of their funds and drawing out their tax-free cash early in this way will not have to leave the scheme to do so. They can stay in the scheme and continue paying in (and their employer will continue paying in too if it is an employer-sponsored arrangement), itís just that the Unsecured part of their fund canít produce any more tax-free cash later on, even on any investment growth on it in the future. Future contributions though, from both the individual and the employer, simply build up other funds that can also be designated as unsecured income later to produce more tax-free cash.
These two new rules are interesting. You can take tax-free cash without drawing down an income from your funds, and you can stay as an active member of your pension scheme while taking cash out in this way. Thereís a third new rule that can combine with these two to give you all kind of options. That rule says that we will no longer be restricted to the erstwhile small amounts of pension investments we can make in any year. In fact, we will be able to contribute up to 100% of our annual salary into our pensions every year if we like.
These three things got me thinking about a hypothetical person who doesnít want to take any tax-free cash from their money-purchase pension pot, but wants to get the maximum possible annuity at age 60 or 65 instead. Such a person could, on reaching the age of 50 before 2010, simply designate all of their fund as Unsecured Pension and take out the maximum Pension Commencement Lump Sum tax-free. If that person is a 40% taxpayer they could then just pay that money back into their pension fund and it would have tax-relief of 22% added to it automatically. In addition the person would get the extra 18% tax back from the Inland Revenue when they do their annual tax form. That could then be dropped into the pension pot too and it would get 22% tax-relief added to it automatically and would generate yet another 18% refund that would eventually come winging its way from the Revenue the next year.
As all this money going into the pension fund from the reinvestment of the tax-free cash and the grossing up for tax is new money, the fund in respect of that would be able to be put aside as Unsecured Income and that would generate another PCLS that could then be reinvested in the pension in the same way. This re-investment can continue as long as PCLS is available to the individual, e.g. where the total of all PCLSs paid remains lower than 25% of the lifetime allowance and the benefits have not been protected.
You can work the figures out for yourself, but itís not hard to get very real and worthwhile increases to the overall value of the original pension fund simply by applying for tax-free cash and immediately reinvesting it. You donít have to reinvest your PCLS, of course, you could just blow it on a holiday or pay off your debts or something, but Iíve just used this as an example of how a combination of the new rules can be used as a way of explaining what they will do. Obviously, anyone who did reinvest their tax-free cash in this way would be effectively giving up their right to a lump sum, but if they were genuinely intending to spend the whole of their pension fund on an annuity anyway they would certainly gain by taking out their cash entitlement and reinvesting it rather than just buying an annuity.
You donít have to be a higher rate taxpayer, though, for surprising and interesting things to happen with this stuff. Take the case of a 59 year-old basic rate taxpayer with a money-purchase fund of £62,400 who wants to use the lot to buy an annuity when they are 60. If £46,800 is designated as Unsecured Pension then it would allow for a Pension Commencement Lump Sum of £15,600. If that was immediately reinvested in the pension scheme it would increase to £20,000 with basic rate tax relief of 22% added by the Inland Revenue. That new fund of £20,000 could then be used to provide £15,000 of Unsecured Pension and pay out a PCLS of £5,000 tax-free. That £5,000 could be put into the pension too and would be grossed up to £6,410. The total of the pension funds available for annuity purchase would then stand at £68,210, almost 10% higher than the original fund of £62,400. Interestingly, if the £5,000 isnít reinvested in the pension the total funds for annuity purchase would stand at £61,800, just £600 less than the original sum of £62,400. So for giving up less than 1% of the original fund, £5,000 worth of tax-free cash is generated.
All of this, of course, assumes that the person concerned has enough earnings in the year in question to allow them to make these payments into their pension, but they can always do this over a number of years if they like.
Itís a hypothetical case really, just to show whatís possible.
27 April 2005
This document is based on Scottish Life's current understanding of the†Finance Act 2004. This may be affected by future changes in legislation and the individual circumstances of the investor. Independent advice must be sought regarding the effect on a specific scheme.