The Value of Pensions

Pensions have come under fire in recent months because of the now-confirmed rumours that they would become subject to inheritance tax from next year. A few people are predicting the death of the pension as a result, but it's not all doom and gloom. This article will look into some of the benefits of pensions that remain unaffected.

What is a Pension?
Before talking about the benefits of pensions, it is probably worth clarifying this fundamental point. For the purposes of discussions about investment rates and tax on death, a pension is generally going to mean a Defined Contribution scheme either in accumulation or drawdown.  This is already complicated, so broken down:

• Defined Contribution means that you pay money into it and the value at the point of retirement can be converted into a retirement income. This is contrasted with Defined Benefit schemes where you accrue an entitlement to a certain amount of income for time served as an employee of the sponsoring company.
• Accumulation is the period during which you build up benefits in your pension rather than spending them.
• Drawdown is a means of paying an income to yourself from your pension investments. The other common option for retirement benefits is to buy an annuity, which is an income for life bought from an insurance company for a capital sum.

Defined Contribution pensions are now the mosty common type of scheme offered by employers because Defined Benefit schemes became too expensive and unpredictable due to safeguarding regulations put into place in the 1980s and 1990s.

Defined Benefit schemes and the State Pension are still pensions, but they are not going to be affected by this new rule.

What are the Rules for Contributions?
The general starting point for contributions into pensions is that they are tax dedictible, meaning you can reduce your taxable income for the year by the gross contribution and save income tax as a result. There are limits to this, in that you cannot normally pay in more than you earn  from employment  and self employment in a given year, with an overall cap of £60,000 each tax year.  This latter limit is complicated because if the full allowance is not used the balance can be carried forward up to 3 tax years and used in future.

Contributions are further complicated by the tax relief process itself. Most schemes operate a "relief at source" basis, meaning any personal contribuitions you make are made net of basic  rate tax, which is then reclaimed internally.  That means if you make a contribution of £8,000 into a personal pension, the trustees will see this as an £8,000 net contribution, will calculate that this would have been equivalent to a £10,000 gross contribution, then will reclaim the £2,000 difference from HMRC on your behalf.  If you are a higher rate taxpayer, the additional tax relief will be available for you to reclaim personally.

When you then invest the contributions, any income and growth derived from the investments is normally tax free unless you invest in non-standard assets.

What About Retirement?
In  exchange for the tax relief on the way in to the pension, you are going to pay tax on withdrawals. There are, however, 2 important caveats to this:

• Most schemes give rise to a Pension Commencement  Lump Sum (PCLS) which is tax free. This is usually 25% of the value for Defined Contribution schemes, subject to an  overall cap of £268,275 at the time of writing.
• When you withdraw funds above this level, they are subject to income tax in the year withdrawn, not the year paid. This means that if you are a basic rate taxpayer in retirement but were a higher  rate taxpayer when you made the contributions, you will have deferred your tax to a more favourable time.

When you come to retirement, you will make a decision of how much PCLS you wish to take (people usually take the maximum from Defined Contribution schemes because it is tax free, but there are reasons to deviate from the norm) and then will decide what to do with the residual balance. This can be:

• Purchase an annuity.
• Start drawing an  income directly from the investment portfolio (drawdown).
• Nothing - you can defer the decision for as long as you like if you don't need the income now. Technically this is a form of drawdown with zero income.

Whatever your option, the important thing to understand is how the pension will help you meet your expenses, which can be discovered by building a financial plan.

What are the Current Rules on Death?
Right now, pensions are more tax efficient than they have ever been on death.  If you die prior to reaching age 75, they can pass to any named beneficiary with no tax payable whatsoever either on transfer or withdrawal.  This means your heirs will benefit from your tax relief on contributions but will never have to pay income tax on the withdrawals as you would if you spent them yourself. If you die after 75, there is still no tax payable on the transfer to your heirs, but they incur income tax on withdrawals they make at their usual marginal rate, so typically 20-40% but  could still be 0% if a non-taxpayer withdraws within their personal allowance.

What's Changing?
This  regime is changing.  From next year, residual Defined Contribution balances will be subject to  inheritance tax at 40% when passed to anyone other than a spouse. Combined with the current income tax treatment for death over age 75, this makes pension death benefits significantly worse than the current treatment. 

It can feel like this makes them unsuitable as savings vehicles, but importantly none of the other tax benefits have changed. You  still get tax relief on  contributions within your Annual Allowance, tax free growth on the investments and a tax free lump sum when you commence your pension benefits.

Pensions are still absolutely fantastic for your own retirement, and without question you should consider them as an  important part of your long term strategy. They aren't as good for inter-generational wealth transfer as they have been for the last decade or so, but they are still great for your personal needs. If you then want to do an inheritance tax planning review to maximise what you can leave to your heirs, there are still plenty of strategies available to you.

More Information
I've written a couple of beginner's guides to pensions and inheritance tax on my website, which yopu're more than welcome to review. If you'd like to discuss anything  you see in them  further, please drop me a message or use the contact  form on my website.

• Beginner's Guide to Pensions:  https://aegisfinancial.ltd/beginners-guide-to-pensions/
• Beginner's Guide to Inheritance Tax:  https://aegisfinancial.ltd/beginners-guide-to-inheritance-tax/