Techzone

It’s 20 years since A-Day, when for a fleeting moment we had a simplified pension framework. Over time, layer upon layer of complexity has been added, arguably making retirement planning even harder to navigate than before. The pace of change shows no sign of slowing, creating real demand for ongoing advice.

Looking back

Pension simplification was introduced on 6 April 2006 (A-Day), replacing a number of complicated pension regimes, each with different tax rules, limits and HMRC approval requirements.

This complexity was seen as a barrier to engagement and a major obstacle to retirement saving and planning. A single set of rules from A-Day attempted to rectify this. However, 20 years on, ‘simplification’ has proved something of a misnomer. Successive governments have taken the easy decision to hack away at pension allowances to balance the books, constantly tinkering with limits and introducing all manner of transitional protections along the way to ensure existing benefits were not lost. This led to a system almost as complicated as the regimes it replaced.

One important aspect has not changed throughout this period. Pensions remain the most tax efficient way of saving for retirement for most people. The combination of tax relief at a saver’s highest marginal rate of income tax during their working lives, and 25% tax-free cash (TFC) available in retirement, with the balance taxed at marginal rates often lower than while working, are compelling reasons to choose a pension to save for retirement. Pound for pound, a pension will usually produce a higher spendable income than an ISA.

Retirement advice landscape today

The fundamental changes affecting the advice process since 2006 include the introduction of ‘pensions freedoms’ in 2015, and the removal of the lifetime allowance (LTA) in 2024. The abolition of the LTA saw the introduction of two new allowances – the lump sum allowance (LSA) and the lump sum and death benefit allowance (LSDBA). To come, we also have the introduction of IHT to unused pension funds on death from April 2027. So, what do advisers need to consider with their clients?

The accumulation phase

The annual allowance and relevant UK earnings currently dictate the maximum contributions that can be made. Tax-efficient personal contributions are limited to the lower of these two measures. Employer contributions aren’t restricted by the employee’s earnings, but still count towards the annual allowance. The employer will usually be able deduct these contributions from their profits before tax. The annual allowance for 2026/27 is £60,000.

The maximum contribution in a tax year can be increased by carrying forward any unused annual allowances from the previous three years. As the annual allowance has been £60,000 in each of the last three years, the maximum tax relievable contribution that can be made this year is £240,000, capped at the individual’s relevant UK earnings for personal contributions. However, the annual allowance in any of these years may be reduced by tapering if adjusted income in a year exceeds £260,000.

This maximum is not far off the maximum ‘simplification’ annual allowance of £255,000 reached in 2010/11.

One aspect that individuals don’t have to consider any longer when saving for retirement is the ultimate size of the fund. There is no longer an LTA charge however much is crystallised, or on attaining age 75. Tax-free cash, however, will be capped at the new LSA.

Saving into a pension also comes with several other benefits, including:

• The potential to reinstate the personal allowance for individuals with earnings over £100,000
• The potential to reclaim child benefit otherwise lost because earnings are over £60,000
• Investments in the accumulation phase grow tax-free
• Basic rate tax relief on contributions up to £3,600, even where the individual has no relevant earnings

The decumulation phase

Pension savings can be accessed from the normal minimum pension age (NMPA), currently age 55, although some clients may be able to take benefits earlier if they have a protected pension age. The NMPA is set to rise to age 57 from April 2028 and this should be factored into retirement plans, particularly for those individuals who reach age 55 before 6 April 2028 but are not yet 57.

Money purchase savings can be used in the following ways (subject to scheme rules):

• to purchase an annuity
• to take benefits as an ‘uncrystallised funds pension lump sum’ (UFPLS) payment which normally will comprise 25% tax-free cash and a 75% taxable income element
• as a drawdown fund where benefits can be taken as a flexible, taxable income.

When a pension option is taken, 25% of the amount being vested is usually able to be paid as a tax-free lump sum. The drawdown option can use this to phase benefits, with income being a mixture of tax-free cash and taxable drawdown payments.

The taxable element of a pension payment will be added to other income earned by an individual and taxed at their marginal rates. The value of pension savings is amplified if the rate of tax relief given during accumulation is greater than the rate paid on pension income in retirement. Even if income tax rates are the same during working life and in retirement, the tax-free cash element will still provide better outcomes than an ISA (assuming same underlying investments).

Tax-free lump sums taken during lifetime are limited to the standard LSA, currently £268,275 (25% of the old LTA). As the LTA has now been abolished, the only charge on withdrawals will be income tax on the taxable element, irrespective of the amount taken.

The Pension v ISA equation

Taking account of the tax incentives for a pension during the accumulation and decumulation phases, the ‘net’ return will normally be greater by saving into a pension when compared with an ISA.

For example, a gross pension contribution of £16,667 would cost a higher rate taxpayer £10,000. Ignoring growth, the return when withdrawn in retirement, even if the individual is still a 40% taxpayer, is £11,667 (£7,500 income after tax plus £4,167 tax-free cash). The same £10,000 invested in an ISA will still be £10,000 when taken. The spendable pot from the pension after all taxes is therefore 16.67% more than an ISA, simply because of the tax treatment.

Had the same individual only been a basic rate taxpayer when drawing their pension, the net return would increase to £14,167, an increase of 41.47% on the ISA.

Death benefits

Lump sums taken on deaths before age 75 will be tested against the LSDBA. The standard allowance is currently £1,073,100. Broadly, this figure will be reduced by tax-free lump sums paid during the member’s lifetime.

Lump sums within the allowance can be taken tax-free. Lump sums in excess of the LSDBA will be subject to income tax at the recipient beneficiary’s highest marginal rate of income tax.

This test and potential tax charge can be easily sidestepped if the member nominates a beneficiary and the scheme allows benefits to be taken in the form of drawdown. Once an account has been created in the name of a beneficiary, any withdrawals will normally be income tax free, even if taken in one go. The exception to this is where benefits are taken after two years of the scheme administrator being made aware of the death.

For deaths on or after age 75, there is no test against the LSDBA, but amounts received will be taxed at a beneficiary’s highest marginal rate, which could be prohibitive if larger amounts are taken.

Hangover from A-Day rules pre-2024

The LTA has been replaced by two new allowances affecting the lump sums available during lifetime and on death – the LSA and LSDBA.

These amounts could be greater than the standard allowances of £268,275 and £1,073,100 respectively if an individual holds any of the following:

• Enhanced protection
• Primary protection
• Fixed protection
• Individual protection
• Scheme specific tax-free cash
• Stand-alone lump sum protection
• Transitional tax-free amount certificate (TTFAC)

None of these can be applied for now, except for the TTFAC which, for some, could improve the amount of LSA and/or LSDBA available. However, if a relevant lump sum has already been paid on or after 6 April 2024, it’s not possible to apply for a TTFAC.

Wealth transfer and IHT

From April 2015, on death under age 75 the tax charge on lump sums from crystallised funds was removed, as was income tax on pension income via drawdown or annuity. The restriction for income to be paid only to dependants was also removed.

This opened an opportunity for wealthier individuals to consider their pension as a wealth transfer vehicle for their wider family, as in most cases pension death benefits are outside the scope of IHT until April 2027.

Following the abolition of the LTA in April 2024, this situation inadvertently became even more attractive.

From 6 April 2027, most unused pension funds will be included in the deceased’s estate when calculating IHT. IHT will be payable on the pension unless there is sufficient IHT nil rate band available to set against the unused funds.

This will have to be factored into any holistic planning. Future funding may be targeted to what might be needed in retirement. Funds already accumulated beyond what may be required in retirement could be used as part of an IHT mitigation plan.

Before deciding on a strategy to reduce IHT, several things need to be considered, including:

• There will be no IHT to pay if unused pension funds are being left to a spouse or civil partner. In this scenario pension savings may need to support not just the retirement years of the member, but also the lifetime of their partner.
• There will be no IHT to pay if unused funds fall within the available IHT nil rate bands of the member.
• Gifts made from tax-free cash will not be outside the taxable estate for seven years. On a practical note, this may also deprive the member of a tax-free ‘emergency’ fund in the future.
• Taking smaller regular withdrawals from a pension could create or increase ‘surplus’ income from which gifts could be made using the ‘normal expenditure out of income exemption’. If successful, such gifts would be immediately outside the estate for IHT. While such gifts will not incur IHT, there may be income tax to pay on the taxable part of a withdrawal. However, the tax-free part of a withdrawal will still qualify as income under the exemption provided all other criteria are satisfied.
• Growth on savings held in a pension will be tax-free. If making gifts, before taking money from pensions, consider doing so from non-pension assets that are exposed to tax on income and gains.
• For deaths before age 75, there will not normally be any income tax to pay for beneficiaries.
• For deaths after age 75, there could be both IHT to pay on unused pension funds and income tax to pay on amounts taken by a beneficiary. Where the beneficiary is a basic rate taxpayer, this could result in an effective rate of 52%. For a higher rate taxpayer, this goes up to 64%. Similar charges were present before pension freedoms in April 2015 when pension death benefits paid to non-dependants were taxed at 55%. This could influence how individuals allocate their estates.

Summary

Twenty years on, pensions remain the best place to save for retirement for most people. The exposure to IHT from next year may influence holistic estate planning in the future, and this will add another layer of complication, but as we have experienced throughout the ‘simplification’ years, pensions have remained and will remain anything but simple.

The need for advice is probably greater than ever.