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28/11/2011

Income ‘recycling’ to give tax relief for drawdown clients

Adrian Walker explains why people who are in drawdown but not taking any income could be losing out, and should seek advice.

Clients could be losing money and missing out on better long-term results for themselves and their beneficiaries.

If a person goes into drawdown and takes a tax-free lump-sum, but then ignores the remaining pension fund, the fund automatically becomes subject to a 55% death tax charge if they die before the age of 75 and the drawdown fund is then paid as a lump sum to approved beneficiaries.

Where there is a surviving spouse or other financial dependant, the capital on the client's death could be transferred to that party to provide income through annuity purchase or income withdrawal to reduce the immediate rate of tax payable. The 55% tax rate would then only apply on the death of the beneficiary on the remaining income withdrawal fund. 

However, if the client instead reinvests all or part of the pension fund back into a pension as a new contribution, these contributions and any future growth on them will not form part of the old drawdown fund. The new uncrystallised fund will not be subject to the 55% tax charge on payment of that fund as a lump sum, if the client dies before their 75th birthday and the value is within the client's Lifetime Allowance. The fund could be paid to the surviving spouse without the need to move it into income withdrawal.

Even if they no longer work, they can still invest up to £3,600 a year. Although the pension income they receive will be taxed at their highest personal rate, they will receive income tax relief on any contributions paid back into a pension at the same rate of tax, thereby avoiding any effective cost.

The new pension fund can be used to provide additional future retirement income through capped income withdrawals or annuity purchase, and they will have access to a further tax-free lump sum.

This type of financial planning is not suitable for people in flexible drawdown. However, they have other options, such as reinvesting the funds into other savings vehicles, such as ISAs.

Something so simple, such as taking the income and reinvesting it as a new pension contribution, can deliver a significant advantage. This especially applies if the person continues working for a number of years and the economic climate improves.

We call it income recycling and there is no reason why people can’t do this, particularly if they are still working. Clients should definitely seek advice because the motivation for drawdown is often the tax-free lump sum and these other issues are often overlooked.

This article is based on Skandia’s interpretation of the law and HM Revenue & Customs practice as at November 2011. We believe this interpretation to be correct, but cannot guarantee it. Tax relief and the tax treatment of investment funds may change.

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