Annuity taxation
All individuals retiring with appropriate pension rights can commute part of the pension fund to a tax free lump sum before buying an annuity. The compulsory purchase annuity (or pension annuities) acquired by a pension fund is taxable as earned income although the annuity will not be subject to national insurance contributions.

This means that for a basic rate taxpayer the tax paid on the income from the annuity is at 20% for the tax year 2008/09 and higher rate tax of 40% would be payable for any amount above the higher rate tax threshold of £36,000 for tax year 2008/09 in excess of any personal allowances.

Any tax free lump sum not commuted will provide an extra income but will be taxable. It is also possible to acquire a purchased life annuity with the tax free lump sum post retirement where part of the annuity is treated as a return of capital and therefore tax free and the balance is taxed at the 20% savings income rate.

For example, the following table shows the income a tax free lump sum from a pension fund can purchase on a gross and net of tax basis. It compares using the tax free cash of £100,000 to purchase extra income from either a compulsory purchase annuity or a purchased life annuity. It assumes that the individuals are basic rate taxpayers, aged 65 and the annuity is level, no guarantee, without proportion payable in arrears and both providing 50% defendants benefits.

In all cases the income from a purchased life annuity net of basic rate tax is greater than from a compulsory purchase annuity. For example, a couple aged 65 will receive a disposable income of £6,050 per year from a purchased life annuity compared to only £5,520 per year from the pension annuity. This means the purchased life annuity provides an extra income of £530 per year.

If the couple were paying higher rate tax the difference would be even greater. The net income after 40% tax from a pension annuity would reduce from £6,900 to £4,140 per year, compared to a purchased life annuity that reduces from £6,330 to £5,770 per year and means the purchased life annuity provides an extra income of £1,630 per year.


Personal pension
With the introduction of Pension Simplification from 6 April 2006, the tax free lump sum from a personal pension cannot be greater than 25% of the the whole fund. This can include taking tax free cash from any protected rights benefits as many people have contracted out of SERPS of S2P.

Previous to A-Day, it would not be possible to take a tax free lump sum from protected rights and this would have the effect of reducing the tax free cash on the whole fund to less than 25%.

Protected rights
Part of a personal pension fund could contain protected rights benefits that can be taken as income from the age of 50 as a result of the Pension Simplification rules from 6 April 2005, one year earlier than A-Day.

The protected rights are ring-fenced when they are received by the pension provider from the Department of Social Security (DSS). They represent rebated payments to a contracted out state earnings related pension scheme (SERPS) and previous to A-Day it was not possible to take a tax free lump sum form these funds at retirement age. SERPS has now been replaced by the state second pension (S2P) that can be contracted out of protected rights.

Since A-Day on 6 April 2006 the income from the protected rights portion can be taken as a 25% tax free lump sum and the remainder to purchase an annuity, currently from age 50. Retirement age limits applying from 6 April 2010 will raise the age protected rights can be taken to 55. Furthermore, the annuity purchased with protected rights does not need to increase each year when it is paid.

Previous to A-Day, protected rights benefits were treated in a different way from the non-protected rights part of the pension fund. Government rules relating to SERPS earned before 6 April 1997 had to provide an annuity income with a fixed rate escalation of 3% per year.

It also provide on the death of the annuitant a compulsory survivors pension for a husband or wife. This must be 50% of the protected rights income even if the annuitant has no spouse or defendants at the time of retirement.

For SERPS rebates earned after 6 April 1997 the annuity income had to increase by LPI escalation although if the annuitant did not have a spouse, a survivors pension was not compulsory.

Retirement annuity policy
Before the introduction of personal pensions from 1 July 1988, retirement annuity policies (RAPs) allowed individuals to save for retirement in a tax efficient manner. The tax free lump sum from a RAPs is calculated in a very different way than a personal pension.

Since A-Day from 6 April 2006, the complex method for calculating the tax free lump sum has been replaced with a straight forward 25% of pension fund.

In the majority of cases this means that the tax free cash they can expect at retirement will be higher. However, providers are not obliged to pay the new maximum tax free cash sums, and it is possible that some may retain the old basis within the scheme rules provided it does not breach the new 25% limit.

Previous to A-Day, the maximum tax free cash from a RAPs cannot exceed three times the remaining pension at retirement date. For the purpose maximising the remaining pension, assumptions can be made in the calculation that do not reflect the actual pension income taken as an annuity. Therefore to maximise the tax free lump sum the highest possible annuity income possible must be achieved.

This is a single life annuity with no guaranteed period payable annually in arrears and with no escalation. The main factors that influence the size of the tax free lump sum are the age of the annuitant, sex and the interest rates at the time. Therefore the older the annuitant and the interest rates, the higher the tax free lump sum as a percentage of the pension fund. The calculation assuming an annuity income of 8% for a pension fund of £100,000 is as follows:

So the remaining pension is calculated as three times £6,451. This is £19,353 or 19.35% of the pension fund. The figure is less than the 25% tax free lump sum from a personal pension and a RAPs would require 11.11% as an annuity income to take higher tax free cash. This means the annuitant would need to be over 70 years of age given the current rate of annuity interest.

AVC & FSAVC
Some individuals would have made extra contributions to pension planning due to a shortfall in their final salary pension with their employer. This could have been achieved through an additional voluntary contribution (AVC) scheme provided by the employer or through a free standing AVC (FSAVC) from an insurance company.

Since A-Day, the Pension Simplification rules introduced from 6 April 2006 allow a tax free lump sum of 25% to be taken from an AVC or FSAVC.

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