When it comes to pensions, everything can feel complicated. Yet, when it’s time to start taking an income, we are faced with the worst pension jargon imaginable. As more people access their pensions by drawing down on their investments, it is important to ensure that they are making the right type of withdrawals.
Among those tapping into their pension pots to cope with the cost of living crisis are hard-pressed working individuals who are still far from retirement. These individuals may be more concerned about their monthly bills than their long-term savings, which could lead them to make rushed decisions that may have more costly consequences than they anticipate.
Recent stats from HMRC reveal that there has been a 15% increase in flexible pension withdrawals in the 2022-23 tax year, amounting to £12.9bn. This is up from £11.2bn in 2021-22 and £9.3bn in 2020-21. Some individuals aged over 55 may have been using their retirement savings to cope with rising living costs.
The average withdrawals per person have remained consistent over the past three years, averaging just over £7,000 per quarter. This indicates that many individuals are making sensible regular payments.
However, what concerns me more is whether people are mistakenly choosing the wrong way to draw down their pensions by opting out of the traditional route of exchanging their investments for an annuity. This brings me to the “uncrystallised funds pension lump sum” (UFPLS), which I believe deserves the wooden spoon award for jargon. UFPLS is a simple method introduced since government reforms in 2015 to access your pension. However, it may not necessarily be the best option. It involves withdrawing money directly from your pension pot, either all at once or in chunks. 25% of each chunk is tax-free, and the rest is taxable based on your income tax rate.
If you’re wondering what “uncrystallised” means, it refers to pension funds that have not yet been used to provide a benefit. This is the opposite of a “crystallised” pension fund, which has either been converted into an annuity, placed in a drawdown scheme, or had a tax-free lump sum withdrawn from it.
The more commonly used alternative to UFPLS is “flexi-access drawdown.” This term is slightly more user-friendly and describes the process of moving some or all of your pension savings into a drawdown fund after the age of 55. With flexi-access drawdown, you have the option to take the 25% tax-free lump sum separately, without needing to take taxable income. The remaining 75% can continue to grow in your drawdown fund tax-free, and you can access it whenever you need.
The main advantage of flexi-access drawdown is the ability to take tax-free cash without any taxable income. This is especially beneficial if you are still working and paying taxes.
Despite this, many individuals still choose UFPLS because it allows them to delay making major pension decisions, such as setting up drawdown or purchasing an annuity. If you’re unsure about how to access your pension long-term, UFPLS can be used as a temporary solution.
However, if you don’t adjust your underlying pension fund investments, they may not be suitable for making withdrawals. If a fund has a high level of equity exposure and the stock market experiences a decline, it can be more difficult to recover while still taking withdrawals. Additionally, without a well-thought-out plan, you run the risk of withdrawing too much in one go. Furthermore, UFPLS doesn’t offer the option to take advantage of the 25% tax-free lump sum available with other options.
It’s also important for UFPLS users to be aware of the Money Purchase Annual Allowance, which comes into effect when you start taking income from your pension pot. This places a cap on further tax-free contributions to your pension at £10,000 per year, compared to the annual £60,000 cap for other pension savers. This can be a significant disadvantage, especially for those who lose their job and need to tap into their pension funds before finding new employment.
Most significantly, since 75% of each UFPLS chunk is taxable, you may end up paying more tax than necessary if you withdraw more than you actually need. Additionally, you may fall into another tax trap.
Since 2015, HMRC has chosen to tax the first flexible withdrawal made in a tax year on a “Month 1” basis. This means that your usual tax allowances are divided by 12 and applied to the withdrawal, potentially resulting in hard-working individuals receiving shockingly high tax bills. While you may expect to be taxed at the 20% basic rate, you could be taxed at up to 40%. This rule can lead to many individuals paying more tax than necessary while others in higher tax brackets may end up paying less.
If you have a regular income or make multiple withdrawals during the tax year, HMRC should automatically correct any discrepancies. However, individuals who make a single withdrawal may be left out of pocket.
Fortunately, it is possible to reclaim any overpaid taxes within 30 days by filling out one of three HMRC forms. Otherwise, you will need to rely on the efficiency of HMRC to repay the overpaid taxes at the end of the tax year.
According to AJ Bell analysis of HMRC data, savers have reclaimed over £1 billion in over-taxed pension withdrawals since 2015. In the first three months of this year, over £48 million was repaid to 15,856 individuals who were overtaxed on their pension withdrawals. This is the highest figure for the first quarter of the year on record and the second-highest for any three-month period since April 2015.
We need to move towards a system where the correct amount of tax is paid on pension withdrawals. The pension shake-up announced by Jeremy Hunt in the last Budget provides an opportunity to achieve this.
There is still a lot to be worked out, but based on what we know so far, UFPLS will remain an option after the lifetime allowance is abolished. However, the maximum tax-free sum will be £268,275, unless certain protections apply, which may make regulation more challenging when the sum is not withdrawn all at once.
In the meantime, it is imperative to find a better phrase than “uncrystallised funds pension lump sum.” Becky O’Connor, the director of public affairs at online pension provider PensionBee, suggests using terms such as “part and part withdrawals” or “direct access withdrawals” instead.
She explains, “This is because with UFPLS, you don’t ‘enter drawdown,’ and the downside of that is you can’t take just a tax-free lump sum on its own; it has to be ‘part and part’.” Either of these options would be better than a definition that leaves most people confused and uninformed.
Moira O’Neill is a freelance money and investment writer. Find her on Twitter @MoiraONeill and on Instagram @MoiraOnMoney. You can reach her via email at moira.o’[email protected].
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