Pensions changes: contractors' six-month review

There seemed to be a general feeling in the media that everyone would flock to their nearest Aston Martin showroom and spend all their retirement funds, once the new pension freedoms were introduced back in April, writes Sat Singh, the chief executive of ContractorMoney.

Six months on and it doesn’t seem the pension landscape has changed all that much, and most savers have been fairly prudent with the newly founded freedoms afforded to them.

To celebrate the six months’ anniversary, let’s look at what  options are now available for contractor pension pots. In simple terms, the new legislation has allowed an individual to draw any level of income / capital from their pension – previously this was always capped.  It has also removed the complex rules around leaving legacy funds and replaced this with an age-related cut-off point for tax purposes.

So, the main options are:

Annuity

Yes, you can still purchase one of these and for some this will still remain appealing given the security of income. Essentially, you are purchasing an income for life and once that annuity has been arranged it cannot be changed later down the line. This is suitable perhaps for people looking to protect a certain level of income, or who perhaps do not have a large retirement fund and require a known fixed income. Given the lack of flexibility though, I would imagine they will remain an unpopular option for many investors, especially for contractors who will perhaps have varying income requirements when they decide to wind down in their later years.

Drawdown

You may well have seen a fair bit of press about this area lately. Although it has been around for some time it has only really come to the fore in the mainstream over recent times. This option is normally used after a member has taken their tax free lump sum (maximum is nearly always 25%). Previously, the income level you could draw under this contract each year closely followed that of annuity rates (known as Government Actuary Department Rates), but now you can draw any level of income you want, whenever you want. The risk with this of course is a) funds may not last the whole of your retirement and b) funds will remain invested and could fall depending on market conditions.  However, some contractors may like the fact they can adapt income to suit their circumstances, especially if they are in the process of working less and like the idea of supplementing their income before they retire completely.

Ad-Hoc payments

If you have no need for your lump sum then you may prefer to draw ad-hoc payments. Known as the rather catchy ‘Uncrystallised Fund Pension Lump Sum,’ you would have the option of taking payments made up of part tax free cash (25%), part income (taxed at your marginal rate). Again, this offers a really flexible option for contractors who may wish to strategically plan for their formal retirement, or to potentially supplement income if there were to be a sizeable gap between contracts.

Just the cash

You can just take your tax free lump sum, or phased amounts, without drawing any income. There is no compulsion to draw any income now, nor is there any upper ceiling age for when you might do in the future.

A few things should be noted in relation to the above. Benefits cannot be accessed until 55 and this will more than likely rise to 57 as the industry aims to keep the 10-year link to State Retirement Age. Also, if you do decide to draw any income from your plan, this will in turn reduce the amount you can tax-efficiently contribute, or your overall pension allowance to £10,000 per annum.

Pensions – An income and a legacy

The main purpose of a pension is to provide an income at retirement and keep you in a lifestyle you have become accustomed to. However, the new rules have also brought some great tax planning opportunities if you wish to leave a legacy to future generations.

By avoiding tax on investment today, you could potentially leave funds to children and grandchildren tax free.  Let’s look at this more closely.

If you were to die before the age of 75 then your whole fund can be left tax free to any beneficiary of your choosing. After 75, any residual funds would be taxed at the recipient’s marginal rate of tax. However, there is no requirement that the dependant draws the funds as a lump sum and funds can be drawn under a drawdown basis as and when they are needed, if at all.  The beneficiary then has the option to leave any funds to a named successor of their choosing, and the same rules will apply to them. This option is only available via drawdown, and not via an annuity.

  Tax on benefits before age 75 Tax on benefits post 75 Legacy pension
Drawdown     The whole fund would pass tax free to named beneficiaries Benefits would be taxed at recipient’s marginal rate. Funds can be left under drawdown and taken flexibly, or not taken at all Yes, funds can potentially be left to future generations as a ‘successors’ pension
Annuity       If a dependant’s pension was selected then this income would be paid tax free until their death. A lump sum is only available if Capital Protection is selected from the outset. If a dependant’s pension was selected then this income would be taxed at their marginal rate until their death No

State of play

As if the pension framework wasn’t changing enough, the government has decided to bring forward the move to a flat rate, single tier State Pension scheme. This is actually good news for a lot of contractors, as outlined below.

Currently, the State Pension is made up of two parts – The Basic State Pension and the Second state pension known as S2P (previously SERPS for our older readers). The Basic State Pension (the bigger part) is built up of qualifying years and you only need to pay small amount of National Insurance to gain a year’s entitlement. The Second State Pension is a salary related top-up based on earnings of £5,824 to £40,040. For many contractors who draw a small salary from their company, this secondary element can be affected and reducing your overall pension value.

From April of next year, the State Scheme will move to a one tier system based on a flat rate payment. This in turn will remove the salary bandings and work wholly on qualifying years. Presently, the years needed to achieve a maximum State pension is 30. This will move to 35 from 2016, although anyone with higher benefits from the older regime will have these protected. 

So, for many contractors going forward there is a potential upswing in the level of State Pension they will receive due to the smaller threshold required i.e. paying NI on earnings of £153 a week or more.

Final thought

The area of pensions is definitely more flexible and seems to be an ever changing one. Perhaps for the better. It is still a complex area of financial planning though and care must be taken when and how benefits are drawn in the future. If in doubt, get some advice.

Tuesday 20th October 2015