Contributed by MW Pensions
21 May, 2013
Contributed by MW Pensions. [www.mwpensions.co.uk]
When can benefits be taken from a SIPP?
At any time after age 55.
Is there an age by which the member must start to take benefits?
Can any benefits be taken tax free?
Yes. Up to 25% of the value of the fund can be taken as a tax free cash sum. So if the SIPP has a total value of £200,000, up to £50,000 can be taken as a tax free lump sum.
What about the rest of the fund?
The balance of the fund is used to provide taxable income over the remainder of the member's lifetime. This can be done in one of three ways:
a) an annuity can be purchased, or
b) the member can keep the SIPP going, investing the assets accordingly, taking income each year out of the SIPP assets (Capped Drawdown), or
c) provided the member has guaranteed "minimum pension income" (see later) of at least £20,000 per annum, they can opt for Flexible Drawdown and take as much income as they like from their SIPP
An annuity can be purchased at any time so this means that the member can start to take benefits via income drawdown and then an annuity can be purchased at a later date. But note that once an annuity has been bought it cannot be "unbought" it it is a one way option.
How does an annuity work?
In essence, the whole or a part of the SIPP fund is passed to an insurance company and in return they will pay an annual income for the remainder of life. The level of income will be fixed each year (or will increase with an inflation adjustment if the annuity is purchased on that basis).
Income must be received each year, but the member can usually choose to receive it monthly, quarterly, half-yearly or yearly and it can be "in advance" i.e. it is paid at the start of the month, quarter or year etc, or "in arrear" i.e. at the end of the month, quarter or year.
Is the income payable under an annuity taxed?
Yes, the income from the annuity will be subject to income tax.
What are the possible downsides of an annuity purchase?
The capital is passed over to an insurance company which then benefits from any residual capital when the member dies, However, there are ways of mitigating that, by arranging for a minimum guaranteed payment period of say 5 or 10 years, and/or arranging for the annuity payments to continue to be paid to a surviving spouse.
Additionally, insurance companies typically base their annuity calculations on the yields underlying long-term gilts, which are historically very low. Some people believe that they can get better investment returns themselves by continuing to actively manage the funds within their SIPP (with advice from their IFA).
What are the advantages of an annuity purchase?
Certainty - that the chosen income stream will be paid for the remainder of life. None of us know how long we will live. It is well documented that life expectancy is increasing rapidly. As part of the annuity contract, the insurance company undertakes to pay the income for the remainder of life (and if the member opts for a continuation of income to their spouse after their death, the insurance company will continue to pay out income until he/she also dies).
Areas that will require advice from the IFA
The IFA will need to advise whether income should be fixed i.e. it is the same level each year, or will increase each year, say in line with price inflation.
They will need to discuss the "death" situation with the member. When the member dies, do they want the income to continue to any surviving spouse or dependent children, and if so, at what level? Do they want there to be guaranteed annuity income payments for say 5 years, or perhaps even 10 years (but if the member opts to have the annuity payments guaranteed for more than 5 years, they cannot also opt to have the provision for a spouse's pension after death).
Obviously, the more "benefits" built in eg inflation protection or spouse's benefits after death, the lower will be the initial income level.
Is there an alternative to an annuity with an insurance company?
Yes, the member can take what is called a "drawdown pension" This is colloquially known as "income drawdown". With this, they keep their SIPP going and keep it invested (taking advice from their IFA), and draw income each year out of the assets of the SIPP. This means that the member retains total control of their SIPP fund.
There are some major advantages:
1. retaining control of the investments
2. the member can choose within a wide range the level of income each year and
3. the member also retains some control of capital on death.
There are some disadvantages:
a. the SIPP assets may not be able to provide an adequate income level if the member lives a long time.
b. if the value of investments within the SIPP falls in value, this may erode the fund and affect the amount of income the fund can generate.
c. there are the regular ongoing administration costs of the SIPP.
d. expectation of life continues to improve and may cause a shortage of funds and hence income in later life.
How does "drawdown" work?
There are two types of drawdown "capped drawdown" and "flexible drawdown". Once the member has reached 55 they can take income each year from their SIPP. The amount taken each year is chosen by the member.
The member chooses the level of income each year within the following ranges:
a. nothing i.e. no income at all, and
b. 120% of the income they would receive if the whole of the SIPP fund was applied to what are called GAD rates. These are published by the Government Actuary's Department (GAD) and are broadly the rates that would apply if the member was to buy an annuity. They depend on age and 15 year gilt rates.
So if the member takes a tax free cash sum and lives off that, they may decide to take zero income for a few years.
The maximum amount can be taken i.e. the 120% of GAD amount, must be reviewed at least once every 3 years (annually after age 75)
If the member has guaranteed pension income (effectively either from the State and/or an annuity and/or a "guaranteed "pension eg from a Final Salary scheme) of at least £20,000 per annum, they can take as much pension via drawdown as they like in any year.
Is the income received taxed?
Yes, the income received under "drawdown" is subject to income tax at their marginal rate i.e. up to potentially 45%.
Is there just one chance to take a tax free cash lump sum?
No. If the SIPP had a value of say £200,000, the member could choose to vest say half of it i.e. £100,000 and take £25,000 as a tax free lump sum. The other £75,000 would then be used for income drawdown and the residual £100,000 would be "unvested".
After another year or two, the remaining £100,000 might have risen, with investment returns, to say £120,000. The member could then "vest" this £120,000 and take a further £30,000 tax free cash i.e. 25%, with the residual £90,000 being used for income drawdown.
This is called "phased" drawdown and can be a useful tool to take income tax efficiently. But it is more costly as we as the SIPP administrator have more work to do!
What happens on death in "drawdown"?
There are three choices:
a) the remaining SIPP fund can be used to provide drawdown, in the same way, for the surviving spouse and any other financial dependants, or
b) an annuity can be purchased for the surviving spouse/dependant(s) or
c) 45% of the SIPP fund can be paid out to dependants or any other party as a lump sum. The other 55% is paid out as a tax charge.
d) the remaining SIPP fund can be paid out to a pre-nominated charity, with no tax payable.
A combination of the above is possible eg 20% could be paid out tax free to a pre-nominated charity and 80% to dependants etc.
If the member opts for "drawdown", can they or their surviving spouse at a later date buy an annuity?
Yes. It is quite common for someone to initially take benefits via income drawdown and, at a later age, use the remaining SIPP fund to then buy an annuity. A common reason for this is that, as time goes by, more and more of the capital will be used for income and there comes a time when it might be more cost effective to buy an annuity (rather than pay ongoing SIPP fees) and/or the security of an annuity might appeal.
Similarly an annuity purchase option is available to the spouse after the member's death.
As we said above, the reverse is not true however. Annuity purchase is one way.
What about HMRC limits?
When a member starts to take benefits (which can be just taking a tax free lump sum) it is classed as a Benefit Crystallisation Event, which means that the total pension assets at the time are checked against the member's Lifetime Allowance. If they exceed the Lifetime Allowance, there is a tax of 55% is applied to the excess.
Please note there are significant risks associated with this decision and this can affect the value of future income. This document is for information only and should not be construed as advice.
This Newsletter is intended for professional advisors only, not members of the general public.
MW Pensions Ltd
Tel: 0151 328 1777 Fax: 0151 328 0707
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