Bernadette Lewis: Pension withdrawals provide advice opportunity

Bernadette Lewis delves into the complicated world of pension withdrawals and outlines all the options available to clients

Pension freedom allows the over 55s to withdraw lump sums from their money purchase savings through three different methods.

For some, an uncrystallised funds pension lump sum (UFPLS) will be suitable. For others, crystallising via flexi-access drawdown (FAD) and taking just tax-free cash will be advantageous. And still, others will benefit from the small pots rules.

Here, we outline the basic considerations.

Uncrystallised funds pension lump sum

Gilou is a group personal pension (GPP) member aged 57. In May 2017, he decides to repay an £18,000 debt by withdrawing a lump sum from his pension savings. He refuses guidance or advice and withdraws a £25,720 UFPLS. He works out that as a higher rate taxpayer, this gives him:

UFPLS                                     £25,720

Tax-free cash 25%                    £6,430

Taxable income 75%                 £19,290

Less 40% tax                              £7,716

Net                                           £18,004

His provider informs him that he’s used 2.57% of his £1m lifetime allowance (LTA) and triggered the money purchase annual allowance (MPAA). (For detailed UFPLS information, see HMRC’s Pensions Tax Manual at PTM063300.)

In February 2018, Gilou’s great-aunt dies. She leaves him a long-anticipated £100,000 legacy, which he’d planned to invest in a pension to benefit from tax relief. Too late, he realises the consequences of taking a UFPLS. His own plus employer GPP contributions use all his £4,000 MPAA.

The annual allowance charge means he’d effectively get no tax relief on any further pension contributions. After moaning about his situation with his colleague Laure, he realises the value of advice.

Laure is also a GPP member and higher rate taxpayer aged 57. She’s been clearing debts she incurred following her divorce and wants to pay off the final £18,000.

Generous employer contributions and a pension sharing credit mean she has a £700,000 GPP fund. She seeks advice on withdrawing a lump sum in January 2018.

Her adviser explains that if their full review concludes that she needs to access her pension, a UFPLS (putting her in the same position as Gilou) is just one option to consider.

Flexi-access drawdown (FAD)

One alternative is for Laure to use FAD. Unlike a UFPLS, which is automatically 25% tax-free cash and 75% taxable income, she can withdraw a lump sum made up of any mix of tax-free cash and income. So she could take the whole £18,000 as tax-free cash:

Crystallise via FAD                      £72,000

Take 25% tax-free cash              £18,000

Keep 75% invested in FAD          £54,000

This option uses 7.2% of Laure’s £1m LTA, instead of 2.57%. But with no tax to pay, she’d use less of her pension fund to obtain £18,000. Laure wouldn’t be taking any flexible income, so she won’t immediately trigger the MPAA. Until she does, she keeps the full £40,000 annual allowance and carry forward – enabling future significant contributions. (Her income doesn’t trigger the tapered annual allowance.)

Small pots

Laure has a third option using the small pots rules. If her provider agrees to split her single GPP arrangement into four, she could withdraw three arrangements worth up to £10,000 each, totalling £25,720.

As with a UFPLS, she’d receive 25% of each pot tax-free and be liable to 40% income tax on the balance, giving her £18,004 net. But unlike UFPLSs, small pots use up none of the LTA, and don’t trigger the MPAA. So this approach can be effective for people with pension savings close to or above their available LTA.

Small pots – possible split

Arrangement 1                          £674,280

Arrangement 2                              £9,000

Arrangement 3                              £9,000

Arrangement 4                              £7,720


Members of non-occupational pension schemes, like Laure, can normally use these rules to withdraw funds from up to three arrangements in their lifetime.

This is provided there’s no more than £10,000 in each arrangement at the time it’s encashed and that this fully extinguishes the arrangement.

Any funds taken under the previous limits of two arrangements worth up to £2,000 also count towards the current limit.

For occupational schemes, the small pots rules apply at scheme level and there’s no limit on the number of schemes this can apply to. (For detailed information, see HMRC’s Pensions Tax Manual at PTM063700.)

Lump sum withdrawals and income tax

The 75% taxable element of a UFPLS and any FAD income are taxed under PAYE rules.

If the provider doesn’t have the member’s tax code, it must use emergency tax. This means only 1/12 of the personal allowance and each tax band are available, so the provider usually deducts too much tax.

Even if the provider has the correct tax code, PAYE treats lump sum withdrawals as if they’re regular payments that the member will receive for the rest of the tax year. So in most cases, providers must still deduct too much tax up front, creating the need for tax reclaims.

Small pots are treated differently, as 20% basic rate tax is deducted from the 75% taxable element. So fewer people need to make tax reclaims, while any additional tax due is paid via self-assessment.

Members can often reclaim overpaid income tax immediately using forms P50Z, P53X or P55 – depending on the circumstances. The forms are available HERE

Bernadette Lewis is financial planning manager at Scottish Widows