Vince Smith-Hughes looks at the tax benefits of using income drawdown
The use of income drawdown has waned a little in recent years. According to ABI statistics the market has fallen by almost 50% over the last five years.
What are the reasons for this? Well clearly the challenging investment climate and the difficulty in maintaining income over the last few years won’t have helped.
But are individuals overlooking the benefits drawdown can bring? Possibly. Not only are there the usual benefits of investment and income flexibility, there are also other strategies that capped drawdown can deliver to form an effective overall tax planning strategy.
Here are a few examples:
Many individuals often take all of their tax free cash even though there is no immediate need for it.
A far more effective strategy can often be to use part of the tax free cash as income. This has several benefits:
• Maintaining the maximum amount of the fund in a ‘tax friendly’ environment – i.e. an unvested pension wrapper.
• Potentially reducing future income tax while meeting income requirements.
• Maximising the benefit on death if the member dies before 75. 100% of the ‘unvested’ fund can be paid out as a lump sum – normally free of inheritance tax.
Recycling to the member pre-75
Taking income and then paying it back into a pension scheme may seem like a lesson in futility, but it can actually have several advantages
• It takes income out of a ‘crystallised’ environment and put its back into an ‘un-crystallised’ one. This means the death benefit advantage mentioned above applies if the member dies before 75.
• Further tax free cash is generated enabling this to be taken in years to come.
The tax paid and tax relief given should cancel each other out. The main caveats are that the member must have the earnings to justify any contribution over £3,600 per annum, and also that care is needed if they’re approaching the lifetime allowance or have some lifetime protection in place. It should also be noted that restrictions apply around recycling of tax free cash, rather than income.
Recycling to a spouse or partner
Taking income and paying into a partner’s name can also have significant tax advantages. Obviously any income drawn is subject to income tax at the members’ highest rate, however tax relief will be given based on the partner’s tax rate once contributions are made. Ideally, of course, one should at least counteract the other, although it’s important to remember that one could be greater than the other. There are several potential advantages to this method:
• A fund can be established for the partner where previously none existed, which could be attractive both from a flexibility of income and a death benefit perspective
• It can help to equalise pension funds between a couple, and thus ensure that both personal allowances are being utilised. From next year, for example, a couple can have income of £20,000 before paying any income tax – assuming their finances are arranged appropriately.
To make the most of this strategy ideally it will have taken place over several years. This allows a reasonable size fund to be built up in the partner’s name. The partner will need to be able to justify the pension contribution in the normal way.
Cascading wealth down the generations
Pensions can often be a great way of passing wealth down to the next generation. Someone in drawdown, for example, could have offspring in their thirties or forties where inheritance tax planning is a key consideration. Taking income from a drawdown plan and paying it into a pension plan for them has the following advantages:
• Income can be paid as a ‘third party’ pension contribution to a plan in the name of the offspring, up to the level as if they were making the contribution. Potentially, therefore, this could be reasonably large sums, thus leading to a substantial fund and income when the lucky recipient reaches retirement.
• The offspring could also benefit from higher rate or additional rate tax relief if appropriate. This could actually decrease their tax bill and increase their net income – even though they haven’t paid the contribution!
• Contributions could fall under the normal inheritance tax gift exemptions – or be treated as exempt from IHT under the normal expenditure out of income rules. Either method or a combination of both should make the contribution ‘inheritance tax friendly’.
While income drawdown has many obvious benefits, exercising some of these strategies can bring additional advantages to not only the drawdown client, but also the family of that client.
Vince Smith-Hughes is head of business development at Prudential
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