Pensions have long been shrouded in mystery. Current rules introduced on 6 April 2015 have made them much more intelligible and attractive.
The two main functions of a pension savings pot are:
- To provide a tax-efficient means of ensuring an adequate income during retirement; and
- To provide a tax-efficient means of leaving part of your estate to your family.
What does “tax-efficient” mean in this context? Quite simply:
- You get basic and higher rate tax relief when you pay into the fund.
- The pension fund grows in a tax-free environment.
- When the time comes to drawdown then up to 25% of the fund can be taken as a tax-free cash lump sum.
There are a few restrictions along the way such as the annual maximum contribution and the lifetime allowance but these do not affect most people. Such rules ensure that the advantage of favourable legislation is kept within agreed boundaries and not exploited.
Drawdown
The term “drawdown” simply means a cash withdrawal from the pension savings pot.
The basic rule is that withdrawals after the 25% lump sum allowance count as taxable income.
The general strategy is to wait until other income is lower and then start drawing down from the pension fund as needed. In this way most people will pay income tax at no more than 20% and some will pay no tax at all.
Example
Rose (aged 70) lives with her daughter and pays her a nominal contribution of £650 a month. Her income consists solely of:
