Taking a tax-free income and making it taxable may seem unusual advice, but it is the best way to ensure David has enough money in retirement after the untimely death of his wife.
David and Julia, both 47, were married with no children. Unfortunately, Julia suffered a tragic accident and died. She had accumulated £200,000 in a defined contribution pension. After an investigation by the trustees of the scheme, they offered David the option of dependants’ drawdown, dependants’ annuity or a tax-free lump sum.
He opted for dependants’ drawdown. Having read about the pension freedoms, he knows he can access this money tax free, should he need to.
Their mortgage was cleared by a joint life first death term assurance policy. David’s income from his job will more than cover his essential and non-essential expenditure. He also has a sufficient emergency fund.
He meets a financial adviser to look at his own pension provision.
David’s adviser conducts a fact-find. She discovers David’s pension provision is slightly lower than what he needs, but by adding the pot he inherited from Julia he should get by in retirement.
David earns £60,000 a year, paying £3,600 into his employer’s net pay pension scheme. His employer contributes £4,800.
His adviser suggests taking the tax-free dependants’ drawdown and putting that into a pension.
Surely taking a tax-free income and making it taxable is nonsense, right? Well not when you go through the numbers, like David’s adviser has.
Not many would refuse a pay increase on the basis you have to pay more tax. The same principle applies here.
Making the move
She advises David to withdraw £25,280 from the dependants’ drawdown pot, and put this into a pension that applies relief at source. This is grossed up to become £31,600. When added to his and his employer’s current contributions, this fully uses David’s annual allowance for the year.
But this is now taxable. Assuming David is a basic-rate taxpayer in retirement, he will be better off. He will not have a lifetime allowance issue, so with 25% of this tax free and the remainder taxed at 20%, David would have £26,860 net from the £31,600. This represents a £1,580, or 6.25%, increase in net income.
Although HM Revenue & Customs will get £4,740 from the withdrawal, this tax year David still has £10,050 of income in the higher-rate tax band. He is entitled to £2,010 back in a tax return. The net position of doing this means £25,280 tax free becomes £28,870 in David’s bank account; £2,010 now and £26,860 (eventually). That has made him 14.2% richer simply by moving the dependants’ drawdown to a personal pension.
After moving all of the money over, £200,000 tax free from dependants’ drawdown becomes £228,580 in David’s bank account. A staggered withdrawal would be required to maintain basic-rate taxpayer status. For increased tax efficiency, he could move over such amounts each year that would fully qualify for higher-rate tax relief.
The funds in the dependants’ drawdown and the personal pension are likely to be the same, representing a big increase in David’s net wealth before any investment returns are achieved.
The adviser has factored in that David has disposable income, and sufficient emergency funds. Also, by taking this approach in year one there is still £174,720 in the tax free drawdown pot.
Over time his tax-free access to the dependants’ drawdown will diminish. But he can access tax-free cash if needed at 55. It would take just under eight years to move the dependants’ drawdown to a personal pension in this way. However, this could be done more quickly by using carry forward or more slowly, which would increase tax relief.
Mark Devlin is senior technical manager at Prudential