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How to unlock more tax-free cash from a pension
Everyone knows how important reading the small print is for anyone with a financial contract – and trawling the technical pages of Chancellor George Osborne’s Budget 2012 has revealed how retirement savers can increase their tax free cash from a pension. Taking advice from a pension adviser is recommended and you can get advice from our sister website www.annuitysupermarket.com
The loophole applies to any retirement saver belonging to an occupational pension scheme before April 6, 2006.
Occupational pensions are workplace retirement plans provided by an employer, regardless of who pays the contributions.
Potentially, thousands of retirement savers could benefit from the hidden change – which simply amounts to a change in the way the tax-free lump sum is calculated on retirement.
A-Day is the key
A-Day – April 6, 2006 – was a watershed for pensions in many ways, but one of the most fundamental changes was replacing the rules for calculating the tax-free lump sum from an occupational pension scheme on retirement.
Before A-Day, a formula computed the amount but after that fateful day, the maximum tax-free lump sum was set at 25% of the fund value.
A-Day rules also let occupational scheme members to protect the tax-free cash rights they held on April 6, 2006 if they were entitled to draw more than 25% of their pension pot tax free.
Effectively, that means anyone in a workplace pension before April 6, 2006, can opt to work out their tax-free lump sum with the government’s formula rather than taking the 25% offered under the new rules.
And there’s more…
Putting tax rules under the microscope
Tax rules let retirement savers in a workplace scheme before April 6, 2006 can increase the amount they take as a lump sum based on two more factors:
• The protected tax free cash entitlement automatically increased in line with a 20% hike in the lifetime allowance on A-Day regardless of investment performance. This means the tax man lets a retirement saver take extra tax free money however the fund has shrunk or grown
• If the fund has increased in value since A-Day, the tax free cash entitlement is increased by 25% of the growth
These conditions are all to do with some technical jiggery-pokery involving an increase of the lifetime allowance from £1.5 million to £1.8 million on A-Day.
Investment growth was discounted by 20% before April 6, 2012, to account for the allowance increase, but the discount was scrapped in Chancellor Osborne’s budget, giving retirement savers a higher tax free cash entitlement if their pension pots have increased since A-Day.
Calculating how much tax free cash you can take
The formula looks complicated, but is quite simple for anyone to work through once they know their protected cash free cash entitlement.
The pension provider should easily give this figure, which varies between pension members depending on their level of contributions, salary and time served.
• Step 1 Take the protected tax free cash entitlement and multiply by the increase in the lifetime allowance.
• Step 2 – Take the investment growth in the fund and multiply by 25%
To help, here’s a worked example that takes a pension fund valued at £100,000 on A-Day, with a protected tax free cash entitlement of £60,000. The current value of the pension fund is £140,000
Calculation part 1 Calculation part 2 Tax free cash
Pre 6 April 2012 £60,000 x 1.8/1.5 = £72,000 25% of £20,000 = £5,000 £77,000
Post 6 April 2012 £60,000 x 1.8/1.5 = £72,000 25% of £40,000 = £10,000 £82,000
Under the new post 6 April 2012 calculation, the amount available as tax free cash has increased by £5,000 from £77,000 to £82,000, an increase of over 6%.
Adrian Walker, Skandia pension specialist, has alerted retirement savers to the potential extra tax-free cash they could unlock from their workplace pensions.
“This is really good news for many people who have a protected tax free cash entitlement in an occupational pension scheme they joined prior to 6 April 2006. The new calculation can greatly enhance the amount of tax free cash these people can take at retirement,” said Walker.
“Many people may not know whether they have a protected cash entitlement from their service up to A-Day in these schemes, and it is really crucial that they check with those schemes to establish what their tax free cash entitlement was at A-Day.
“If they look to transfer their occupational pension scheme they need to speak to their financial adviser to ensure they protect this valuable benefit, or risk reducing their tax free cash entitlement to 25% of the value of their pension savings.”
Fixed protection warning
A final small print warning – all rules have exceptions and this Budget 2012 loophole does not apply to retirement savers who have applied for fixed protection.
Their tax-free lump sum revaluation of A-Day cash is still on the pre-April 6, 2012 basis which subtracts the A-Day fund value increased by 20% from the current fund value to determine whether there is any additional tax free cash entitlement.