Contractors aged 55 and over may find that a pension drawdown arrangement offers a flexible and tax efficient mechanism for accessing some of their pension savings, at the same time as securing a pension income and continuing to grow their pension pot.
“Pension drawdown can allow contractors to release up to 25% of their pension fund as tax-free free, leaving the rest of their retirement savings to continue to appreciate in value,” explains Andrew Gains of contractor specialist independent financial advisers ContractorFinancials.
“The flexibility afforded by pension drawdown suits the flexible contracting lifestyle, particularly for those contractors seeking a ‘phased retirement’. It is a useful tool for those who wish to downshift their contracting career at the same time as maintaining their income through a combination of fewer contracts and the pension income from the drawdown.”
Income security: annuities versus a drawdown
According to Gains, most contractors on reaching retirement age buy an annuity to secure their income and ‘crystallise’ their pension assets. “An annuity provides a secure income for the rest of the contractor’s life, regardless of how long they live.
“However, once bought it can’t be changed, and the fixed return depends on many factors, such as gilt yields and mortality rates, that are beyond a contractor’s control. So the potential income can vary widely according to when the contractor chooses to purchase the annuity. Annuities may also cease to pay out, or only pay a smaller share to a surviving spouse or partner when the contractor dies.”
In contrast, Gains says a pension drawdown allows a contractor to extract a tax-free lump sum, take an income and continue to invest in the pension. The ‘uncrystallised’ pension asset – in other words the cash left in the pot – can continue to grow.
But a pension drawdown comes with a health warning, because the fund’s growth and the security of the income drawn on the fund are not guaranteed.
A pension drawdown offers flexibility
“The advantage of a pension drawdown is that it offers contractors a huge degree of flexibility, which works entirely in favour of the equally flexible contracting business model and lifestyle.”
For example, a contractor turning 55 could adopt a phased retirement and potentially draw down 25% of their pension fund as tax-free cash, use a lump sum from the fund to purchase a smaller annuity to provide a fixed income for life, and continue to invest company profits into the reminder of the fund so the pension pot continues to grow.
“After the first pension drawdown, a contractor might over several years generate greater profits than originally anticipated. These they can invest directly into the company pension fund, and then perform another pension drawdown perhaps five years later,” adds Gains.
And, unlike an annuity, if a contractor dies then the remainder of the fund is paid to the contractor’s beneficiaries as a capital sum, although it will attract a 55% tax charge. However, any benefits which have not been ‘crystallised’ to provide benefits can still be paid out as a tax free lump sum death benefit before the age of 75.
Another huge potential benefit of drawdown is the option to utilise the ‘flexible drawdown’ option. If a contractor has a secure pension income of £20,000 or more from other pension plans, including the basic state pension, it may well be possible to draw the entire fund down, or draw it to a level that the contractor can personally control.
“This scenario could fit many contractors’ circumstances as they inevitably build up pension pots from various different employment types over their working lives,” adds Gains.
Calculating pension drawdown using ‘GAD tables’
According to Gains, the amount of drawdown cash that can be taken from a pension fund varies with ‘gilt’, or government debt yields over a fixed period, the contractor’s age and their gender.
The advantage of a pension drawdown is that it offers contractors a huge degree of flexibility, which works entirely in favour of the equally flexible contracting business model and lifestyle
Andrew Gains, ContractorFinancials
Gains explains: “The Government Actuary Department (GAD) has prepared online calculations, known as ‘GAD tables’, which allow contractors to calculate how much of a drawdown they can take.”
The drawdown is calculated by dividing the contractor’s GAD score, taken from the tables, by one thousand and multiplying the result by the value of the contractor’s pension pot. “Age and 15-year gilt yields are the major influencers, so clearly the worse the government bond market is performing, the greater the drawdown a contractor can take,” he adds.
And the flexibility of pension drawdown can really pay off for a contractors who may be considering reducing their hours rather than retiring altogether. This is because contractors can choose flexibile income levels of income within the GAD limits so their pension could gradually increase as a contractor’s working hours decline.
The benefits of pension investments for limited company contractors
“Pensions remain a hugely tax efficient mechanism for dispersing contracting profits,” explains Gains. “Contractors who run a company pension scheme transfer income directly from their limited company into the scheme. The payments are a legitimate business expense.”
In fact, as Gains highlights, company pensions reduce the company’s profits and resulting corporation tax: “A company pension scheme also circumvents private pension rules that restrict contributions to the level of a worker’s salary. That means contractors who only draw a small salary and would be restricted in what they could pay into a personal pension can divert profits of up to the tax-free cap of £50,000 a year into a company scheme.
And if a contractor has not used up the previous three year’s pension allowance, they could invest as a much as £200,000 in a single year, because the rules allow contractor’s to utilise unused pension allowance in a single year.
“A pension drawdown won’t suit every investor’s personal risk profile, but it does add a level of flexibility that is particularly suitable for contractors,” says Gains. “Because contractors have flexible working practices, those considering a drawdown should consult an independent financial advisor with specific experience in the contracting sector.”
Published: Wednesday, January 25, 2012
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