Bernadette Lewis: Taking tax advantage of drip feed drawdown

Bernadette Lewis looks at the benefits of drip feed drawdown, specifically, the tax advantages advisers can bring to clients

Drip feed drawdown is a variation of flexi-access drawdown (FAD).

It can provide tax-efficient pension income for clients with no specific need for their tax-free cash (TFC) as an up-front lump sum.

It involves phased crystallisations of pension savings into FAD, providing pension income by combining small, more regular amounts of TFC and taxable withdrawals. This can minimise tax on each income payment and potentially give rise to a greater value of total TFC over time.

Until the member has used up their TFC entitlement, each crystallisation can create:

  • an income payment made up entirely of TFC with the balance kept invested in FAD
  • 25% TFC plus 75% taxable income
  • any mix between these two limits of TFC, taxable income and funds left in FAD.
Example

£1,000 pension income funded from drip-feed drawdown – three approaches

1.     Crystallise £4,000 – take £1,000 as tax-free cash 2.     Crystallise £1,000 – take £250 tax-free cash and £750 taxable income 3.     Crystallise £2,500 – take £625 tax-free cash and £375 taxable income

 

It’s also possible to use uncrystallised funds pension lump sums (UFPLS) to provide a restricted form of drip-fed pension income. In this case, every UFPLS must be made up of 25% tax-free cash and 75% taxable income.

Using UFPLS or taking any FAD mix of TFC and taxable income triggers the money purchase annual allowance.

With drip feed drawdown, less of the total withdrawal is subject to income tax. This saves the member tax and has the potential to improve how long their pension savings last.

Paying less tax on withdrawals, particularly in the early years, means more funds can remain invested and have a longer opportunity to produce further growth.

Example

Jen is 60, has just left employment and started to receive a £3,750 defined benefit (DB) pension. She also has a £105,000 money purchase (MP) pot. She needs to supplement her DB income until her state pension starts. She’s also considering returning to part-time employment after an extended break. Her current income needs are around £14,500 a year.

In year one Jen withdraws £10,800 from her pension made up of £2,700 TFC and £8,100 taxable income. The £8,100 plus her DB pension income of £3,750 uses up all her £11,850 personal allowance (2018/19), meaning she can receive the full £14,550 free of tax.

Alternatives, such as taking full TFC, or perhaps £10,800 of TFC to fund her income, would have ‘wasted’ her personal allowance and used up her TFC unnecessarily.

Jen can continue to receive income payments made up of a mix of TFC and taxable income each year and adjust the level of withdrawals as the tax bands change or if she decides to start working part-time.

 

Jen’s example demonstrates how it’s possible to manage funds to pay no tax at all, along with minimum use of TFC. Drip feed drawdown can also be used to reduce an income tax liability in other ways.

For example, by using a suitable mix of TFC and taxable income to keep a client’s total taxable income within the basic or higher rate bands if they’re close to these margins.

Example

Rick is 57 and wants to start to reduce his hours. If so, his £53,350 a year income will reduce by £12,000. However, his outgoings will remain steady for the next few years until his children finish university. He could access a substantial £700,000 MP pension.

Ignoring employee NI for simplicity, Rick needs to replace £8,200 net income. With the 2018/19 higher rate band at £46,350, £5,000 of the £12,000 he’s losing was taxed at 20% and £7,000 at 40% – a total of £3,800 in tax.

Option 1
Crystallise £32,800 each year and withdraw £8,200 TFC. This option uses up Rick’s TFC fastest. It reduces the amount of immediate tax, but Rick is always likely to be at least a basic rate taxpayer so this just defers tax on income from the crystallised funds to a later date.

Option 2
Crystallise £10,300. Take £2,575 as TFC and £7,725 as income: £5,000 taxable at 20% and £2,725 at 40%, giving total tax of £2,090 and a net payment just over the required amount of £8,210. This option uses the least TFC, but also means Rick pays some higher rate tax.

Option 3
Crystallise £16,800. Take £4,200 TFC, £5,000 income, and leave £7,600 invested in the crystallised fund. The £5,000 income uses up the rest of Rick’s basic rate band and will be taxed at 20% leaving £4,000. This together with the £4,200 TFC provides a total of £8,200. This balances using TFC and keeping the taxable withdrawal within his basic rate band.

Rick’s example illustrates how drip feed drawdown options can be tailored to individual clients’ specific circumstances. The options can also be reviewed and adjusted as circumstances change.

Another benefit of taking TFC gradually is that a member retains more of their funds in the uncrystallised part of their pension fund.

They’ll potentially increase the total monetary amount of TFC they receive from their pension fund. If a member crystallises their full pension pot and takes all their TFC in one payment, no further TFC will become available unless they make further contributions.

Spreading their TFC offers the possibility that the uncrystallised part of their pension fund will benefit from investment growth, generating additional TFC entitlement over time.

Bernadette Lewis is financial planning manager at Scottish Widows