How you can access your pension bit by bit and get extra tax free cash.
Last month I started my series of occasional ‘Technical Notes’ when I looked at the Residence Nil Rate Band. Continuing the series today I’m jumping into pension withdrawal which has some of the greatest potential to confuse, not least because of the terminology used. For example, in this piece I’m looking at Benefit Crystallisation Events, one of which is defined as: ‘If regulations under section 164(1)(f) so provide, the happening of an event prescribed in the regulations in relation to payment prescribed in the regulations.’ Eh?
So what exactly is a Benefit Crystallisation Event? There are 13 of them, and in most cases it is an event where value is removed from a pension fund, such as taking some tax free cash, drawing an income or payment of a death benefit. There is no way I can go through all thirteen and expect to keep your attention, so I will concentrate on just one of the most common situations; phased withdrawal from a personal pension.
Until Income Drawdown was introduced in 1995, annuity purchase was just about the only option for getting anything out of a pension fund. Income Drawdown has gone through many changes since then but the fundamental principle remains the same – that you withdraw cash from the pension fund leaving the rest still invested. It is commonly understood that 25% can be withdrawn as a tax free lump sum (it used to be called Tax Free Cash, but is now called Pension Commencement Lump Sum. I will stick to the former for this piece, because who doesn’t understand ‘Tax Free Cash’?). If you have a pension fund worth £800,000 you can withdraw £200,000 tax free; but let’s say you only need £40,000, not £200,000. Here you could start a partial, or phased, crystallisation of the pension fund. The best way to explain how it works is with an example.
So, sticking with these numbers, your pension fund is worth £800,000 and you need to withdraw £40,000 to build that conservatory you always promised yourself. The first step is to designate £160,000 to be opened from which you take 25% as tax free cash. What are you left with? A pot of unopened pension worth £640,000 and a pot of opened pension worth £120,000. Your pension overall is worth £760,000 and you have £40,000 in your pocket, or rather, you have a new conservatory.
That £640,000 of unopened fund and £120,000 of opened fund are both still invested and enjoying investment growth and, after a period of time, have increased in value to £700,000 and £130,000 respectively.
Your son needs a bit of help with a flat he wants to buy and you therefore decide to give him £100,000. To achieve this you designate £400,000 of the £700,000, take out the £100,000 tax free cash which therefore adds another £300,000 to the opened fund pot.
You now have £300,000 of unopened fund, £430,000 of opened fund and you son has £100,000 of your tax free cash (are you sure that was a good idea?).
Some more time passes and these two pots of money have grown to £400,000 and £550,000. Your daughter, mindful of her brother’s good fortune, persuades you to give her £100,000. You can do this now by designating the rest of the unopened fund, withdrawing the tax free cash which transfers the last £300,000 to the opened fund pot.
The net outcome of this is that you now have no unopened pension funds left, you have £850,000 of opened pension fund and you have withdrawn a total of £240,000 as tax free cash. Had you withdrawn the maximum tax free lump sum back at the start, you could only have withdrawn £200,000, so by phasing the withdrawals you have benefited from an additional £40,000 of tax free cash.
You finally need to start a regular withdrawal for yourself so that you can properly retire. As you now only have opened pension funds, anything you take out will be treated as income and taxed accordingly.
So that explains how phased pension fund withdrawal works. It is a deliberately simplistic example and there are many factors that can lead to complications, all or which point to the need for access to quality advice. I know of situations where people have eschewed advice and have ended up stuck on an administration roundabout and not getting their hands on the cash when they think they will, or worse, getting it wrong and facing substantial tax charges and penalties.
Next time I’m looking at another Benefit Crystallisation Event – one in particular that can come with a bit of a nasty surprise.
Philip Chandler APFS, CFPTM, Chartered MCSI
Chair of Aspinalls Technical and Investment Committee