Uses of Flexi-access drawdown (FAD)
Flexi-access drawdown (FAD) is a new product/option introduced in April 2015. In our view there will be five main uses:
- To allow the pension holder to take just the tax-free lump sum and leave the rest invested
- To allow you to strip out the fund
- To allow you to strip out the fund but lessen tax
- Use like a bank account, and make occasional withdrawals
- To aim to provide a long term income
- To leave the money invested to pass on inheritance tax free
Your existing provider may not offer you the option to use flexi-access drawdown, and your only option may be to transfer it to another provider to do so. If you want to discuss this please then contact us online or phone 0800 011 2713.
Taking tax-free cash only
Flexi-access drawdown will allow a pension holder to just take the tax-free cash. The advantage of this is that it allows an investor to take funds without tax to pay, and also allows the rest of the fund to remain invested.
An example may help. Due to a previous lack of prudence, Mr Osbourne aged 55, finds himself with some debts he cannot manage to pay off. He has made cutbacks in the household budget, but still finds that he cannot bring the debts under control. These debts amount to £20,000 and are mainly on credit cards charging 23% interest per year. This means he is spending £4,600 per year on just maintaining his debts, and the amount outstanding is not reducing significantly.
He cannot borrow more funds to pay off these as he has a poor credit rating, and does not want to go bankrupt as he owns his own house. He has £80,000 in a personal pension. He enters flexi-access drawdown, and takes £20,000 tax-free cash only. He leaves the remaining £60,000 invested, and will not need to take any more out of it until he retires at age 66. He may buy an annuity at age 66, or take withdrawals from the pension at age 66.
He will decide when he gets to retirement.
He uses the £20,000 to pay off the credit cards, and saves himself £4,600 per year in interest. This he feels is guaranteed saving, as he feels that if he left this money invested in the pension it would not grow by 23% per year.
Once the credit card is paid off, he then has £4,600 disposable income, which he can use to invest more into a pension, or for other purposes.
Two key advantages are that the remaining 75% is left in the pension, and can be left until his income drops, and potentially take income at a lower rate of income tax. Additionally, because he has not taken any taxable withdrawals, he can continue to pay up to £40,000 into a defined contribution pension.
Stripping out the fund in one go
It is possible to use flexi-access drawdown to strip out the entire fund in one go. All the 25% tax-free cash and the remaining 75% that is taxable.
Mr Webb wants to take his pension, and buy a new sports car. He has a pension fund worth £60,000. He has the state pension and an annuity in payment and these pay £12,386 per year. He feels that this income is enough to maintain his lifestyle. He takes the £60,000 in one go through flexi-access drawdown (he could also do this through UFPLS). He takes £15,000 tax free.
The remaining £45,000, as he is taking in one go is all is subject to income tax. This works out as follows after tax:
£30,000 taxed @ 20% = £6,000
£15,000 taxed @ 40% = £6,000
Therefore, the £60,000 after tax ends up being £48,000. (£45,000 after tax ends up being £33,000 after tax if we discount the tax-free cash).
(The same outcome can be achieved in this example by using Uncrystalised Fund Pension Lump Sum, and taking benefits all in one go).
Strip out fund over a number of years
In the same way as it is possible to take all the pension fund in one go, it is also possible to do it over a number of years.
Another example might help. Ms Sturgeon is approaching retirement, and has an outstanding interest only mortgage of £85,000. She has an income of £20,368. She is a little more canny than Mr Osbourne, and her mortgage is on a very low interest rate, so instead she looks to use flexi-access drawdown over a number of years, using a no risk investment approach. After taking the tax-free cash, she takes just enough out of the pension to keep her below the 40% tax bracket.
If she took the money out over just one year, this is what it would look like.
£25,000 tax-free cash
£75,000 subject to income tax
£20,000 taxed at 20% = £4,000
£55,000 taxed at 40% = £22,000
This provides her with £74,000. Not enough to pay her mortgage.
Please note too if total income/taxable withdrawal exceeds £100,000 then for every £2 over this, and up to £121,200 it reduces the personal allowance by £1, this effectively means a tax rate of 60% on the first £21,200 in excess of £100,000. Additionally if income exceeds £150,000 then income tax would be 45%.
Instead, she takes the money over a number of years.
Year 1. £25,000 tax-free cash
£20,000 taxable - leaving £16,000 after 20% tax
This provides £41,000. This she uses as a partial payment off of her mortgage
In year 2
She takes another £20,000 (£16,000 after 20% tax)
In year 3
She takes another £20,000 (£16,000 after 20% tax)
In year 4
She takes the remaining £15,000 (£12,000 after 20% tax)
So, she ends up with £25,000 tax free cash, and £60,000 after tax on the remaining £75,000 over the four tax years. This means that the total she receives is £85,000.
So by taking the money out over the course of four tax years she can save herself £11,000 in tax (four tax years could be as little as 36 months and 1 day). There may be many other reasons to take the money out like this, perhaps just to spend and enjoy it.
Use like a bank account, and make occasional withdrawals
It would be possible to use flexi-access drawdown to take a tax-free lump sum, and then take withdrawals as and when required. Again, this may be done to avoid/manage income tax. Again another example may help.
Mr Cameron is 64, and independently wealthy and no longer works. He has substantial savings in ISAs, owns a number of houses, and has no debts. He has £100,000 in a personal pension. He does not need an income from this pension as his other assets meet all his day-to-day bills, and he has a £30,368 per year pension from a final salary scheme. He wants to enjoy this £100,000 and spend it as and when he wants. He invests this in a flexi-access drawdown contract, and puts the money in a cash fund (bank account type investment). He takes £25,000 from his pension as a tax-free lump sum, and he spends this on an extension on his house.
One year later, he decides to have a 65th birthday party in May, and also invite his former university friends. They have expensive tastes so he takes £10,000 out of his flexi-access drawdown pension. After tax of £2,000 he has £8,000 left. He uses this to pay for the party at a local restaurant, and pays for it up front in March.
The party goes ahead in May, and unfortunately the behaviour some of his former university friends gets out of control. They cause damage to the restaurant. Mr Cameron feels responsible, and to avoid embarrassment agrees to pay for the damage. This is £6,000. So, Mr Cameron (in a new tax year) takes out £7,500 from his flexi-access drawdown. After 20% tax this amounts to £6,000 which pays for the damage.
To provide a long term ongoing income
This is how drawdown, in its various formats has been used for many years (since drawdown was introduced in 1995). The aim would be to take the tax-free cash, and then withdraw an income, whilst having the fund invested. The hope would be that the level of growth would be sufficient to maintain the income.
Again, another example may help. Mr Clegg is 65, and has a pension worth £200,000. He has a state pension of £7,000 per year. He needs another £4,500 per year extra to maintain his standard of living. He doesn't want an annuity, therefore enters flex-access drawdown with his £200,000.
He takes £50,000 tax-free cash, which he will use for holidays, and help pay off his grandson's student loans.
The remaining £150,000 he invests in the flexi-access drawdown, and invests this in a number of funds invested in shares and other such assets. He withdraws £375 per month (£4,500 per year). This is a withdrawal of 3% per year, and long as the fund grows by 3% after costs, then he will maintain the fund value. There is no guarantee of this, but the lower the withdrawal then the greater the chance of maintaining the fund.
Flexi-access drawdown does not however have any restrictions on how much can be withdrawn. So, if he were to withdraw say 10% per year, then it would be unlikely this level of income could be maintained for very long.
Flexi-access drawdown and aid inheritance tax
This is a new aspect of the legislation. If you have a potential inheritance tax issues, and a pension, then it might be better to not take the pension benefits. Pensions are held in trust, and therefore do not form part of your estate for inheritance tax.
If you take money out of the pension, then you might pay income tax on it (except of course the tax-free cash). If the pension money is not spent, once it comes out of the pension, then it could incur inheritance tax too.
A further example may help. Mr Miliband is 65, and owns his own mansion worth in excess of £2,000,000. He is married, and has substantial assets in cash ISAs worth £300,000. He has a state pension of £6,000 per year, and an annuity in payment paying £6,000 per year already. He also has a pension worth £400,000 he has not taken benefits from. He takes £100,000 tax-free cash, and puts the remaining £300,000 into flexi-access drawdown (FAD).
He takes income from his pension. He invests in a cash fund inside his FAD. He accepts this offers him no growth, but ensures his fund will not fall in value. He withdraws £20,000 per year from the remaining £300,000. This provides him with £16,000 per year after tax at 20%.
He is keen to avoid paying inheritance if possible, and happy to use any legitimate means. His state pension and annuity are not enough to meet his day to day expenses. He does not want another annuity, and can therefore use his cash worth £300,000 to fund his retirement, or his pension.
After 10 years he dies. He has withdrawn £200,000 from his pension and paid £40,000 income tax on it. He has £100,000 left in his pension, and £300,000 in his cash ISAs and a £2,000,000 mansion. The £100,000 in the pension is exempt from inheritance tax as it is in his pension. His estate is then worth £2,300,000, and this is potentially chargeable to inheritance tax (minus the nil rate band).
Instead he decides to take £16,000 per year from his cash ISA, and spends this. As there is no tax to pay he only needs to withdraw £16,000. After 10 years, he dies, having withdrawn £160,000. So he ends up with his £2,000,000 mansion and £140,000 in his ISA. This means he has an inheritance tax liability on £2,140,000 (minus the nil rate band).
Option 2 is far more tax-efficient as it avoided £40,000 of income tax, and £40,000 inheritance tax.
The above examples are of course hypothetical examples, and there will be many different reasons to enter flexi-access drawdown. And we can help you through the process.
If you have a question about your pension or want to discuss flexi-access drawdown in more detail and how it can benefit you, then contact us online or phone 0800 011 2713.
If you can't find the information you're looking for on the website, or you want to know more or have a question, or just want to chat through some details about your pension then please feel free to contact us, without obligation. Either contact us online or call 0800 011 2713.