Since April 2015 there has been greater choice about how to withdraw funds from defined contribution pension schemes.
Flexi-access drawdown People over 55 years of age can now start to withdraw money from a pension scheme. The first 25% of any withdrawal is tax free and the remaining 75% of that withdrawal is moved to an ‘income drawdown’ fund. If withdrawals are made from this ‘income drawdown’ fund then these are treated as income and are taxable at the individual’s marginal rate of tax.
The 25% tax free withdrawal is limited to 25% of the individual’s lifetime allowance, which becomes relevant for individuals whose various pension pots exceed the ‘lifetime allowance’. The lifetime allowance was £1,250,000 for the tax years ending 5 April 2015 and 5 April 2016. This has been reduced to £1,000,000 from 6 April 2016.
People often start to withdraw funds from their pension scheme(s) shortly after ceasing to work as they find they need the money. However, if they do not need the money they have various options:
Not withdrawing any funds
Withdrawing some or all of the 25% tax free amounts then waiting before making withdrawals from the ‘income drawdown’ fund
Withdrawing some or all of the 25% tax free amounts together with making some withdrawals from the ‘income drawdown’ fund
The funds can be used to purchase annuities, either one annuity or a number of annuities. Monies paid from these annuities will be treated as income and are taxable at the individual’s marginal rate of tax.
The ability of individuals to withdraw funds from their pension schemes is not dependent on them being employed, self-employed or retired. That is unless the pension scheme has some restriction, for example defined benefit schemes will generally not be as flexible and the pension scheme rules may stipulate that pension withdrawals can only be made after the individual ceases to be employed by the employer who is linked to that pension scheme. In general for defined contribution schemes, individuals can start withdrawing funds as soon as they are 55 years old, whether or not they remain in employment or self-employment.
Tax relief on contributions An individual may make unlimited contributions and tax relief is available on contributions of up to the full amount of his relevant earnings or, provided the scheme operates tax relief at source, on contributions of up to £3,600 even if relevant earnings are lower than that.
Although contributions can be paid after an individual has reached the age of 75, they are not relievable pension contributions and do not qualify for tax relief.
The annual allowance However, there is an ‘annual allowance’ which means that if annual pension contributions exceed the annual allowance, then the excess is subject to tax at the individual’s marginal rate of tax. Contributions to defined contribution schemes are taken into account together with increases in pension rights under defined benefit schemes.
The annual allowance for the previous few years has been as follows:
2014/15 onwards £40,000 2011/12 to 2013/14 inclusive £50,000.
Unused annual allowance can be carried forward for up to three years.
The annual allowance applies across all of the schemes an individual belongs to; it is not a ‘per scheme’ limit and includes all of the contributions made into the schemes including from the employer and anyone else such as a relative.
If the annual allowance is exceeded in a year then tax relief will not be obtained on any contributions paid that exceed the limit and the individual will incur an annual allowance charge.
The annual allowance charge will be added to the rest of the taxable income for the tax year in question. If the annual allowance charge is more than £2,000 the individual can ask the pension scheme to pay the charge from that individual’s pension pot.
Reduction in annual allowance for high earners from 6 April 2016 The annual allowance will be tapered for individuals with an ‘adjusted income’ of over £150,000. ‘Adjusted income’ is arrived at by adding back pension contributions to income. This is to prevent the avoidance of the restriction by sacrificing salary in exchange for employer contributions.
The taper operates by reducing an individual’s annual allowance by £1 for every £2 by which adjusted income exceeds £150,000, up to a maximum reduction of £30,000. The carry-forward of unused annual allowance will continue to be available, but the amount available for carry-forward will be the unused tapered annual allowance. Example Salary £110,000 Benefits in kind £40,000 Taxable rental income £70,000 Adjusted income £220,000 Taper (£220,000 less £150,000) x ½ = £35,000 but limited to £30,000 Reduced annual allowance £40,000 less £30,000 = £10,000
Employee is in employment pension scheme to which employer contributes 9% of salary and employee contributes 6%.
Total pension contributions are 15% x £110,000 = £ 16,500 This is £6,500 above the reduced annual limit of £10,000 Tax charge would be £6,500 at 45% to give a tax liability of £2,925 Changes to annual allowance If the individual has taken flexible benefits which include income, such as an ‘uncrystallised funds pension lump sum’ (UFPLS) or flexible drawdown with income – and that individual wants to continue paying contributions to a defined contribution pension scheme – then a reduced annual allowance of £10,000 will apply towards that individual’s defined contribution benefits.
The reduced allowance will apply if the individual has withdrawn more than the 25% tax free pension commencement lump sum (PCLS). The reduced amount is known as the ‘money purchase annual allowance’ (MPAA), and includes both the individual’s own contributions and any other contributions paid on their behalf, such as employer or a third party. Unused annual allowances from the previous three years cannot be used to warrant a higher contribution of £10,000 towards that individual's defined contribution benefits.
The money purchase annual allowance will only start to apply from the day after flexible benefits have been taken and so any previous savings are not affected.
If an individual’s allowance drops to £10,000 for one pension scheme that individual should tell other pension schemes they are in within 13 weeks.
Individuals who are over the age of 75 who have started to take flexible benefits which include income are also affected by this £10,000 limit and if they make pension contributions tax relief will not be available on those contributions.
Pension Input Period (PIP) The annual allowance applies to the total pension contributions made to an individual’s schemes and/or benefits built up over a period called the pension input period that ends during the tax year. A pension input period normally lasts for one year, but doesn’t necessarily cover the same dates as a tax year. The pension input period is specific to each pension arrangement so an individual with a number of pension schemes may have different PIPs for each. The pension provider or scheme administrator should be able to provide the amount of contributions or value of accrued benefits during the pension input period.