Osborne’s pension revolution

The more we learn about George Osborne's pension reforms, the more it becomes obvious that they amount to a pensions revolution.

Earlier this week, the chancellor published his Taxation of Pensions Bill, which gives us more clarity on what is being proposed. In particular, he highlighted the fact that the rules governing the 25% tax-free lump sum will be much less stringent from next April.

Let's imagine that you have a £100,000 pension pot and you've not made any withdrawals until now. Under the current rules, you can take out £25,000 right now as a tax-free lump sum.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Once you've done that, you can use the remaining £75,000 to buy an annuity that will give you an income for life. Or you could use the £75,000 to set up an income-drawdown policy where you can continue to withdraw money while the remainder of your pot stays invested.

The first set of reforms, announced in March, made the rules on income drawdown much more flexible.

However, some further rule changes, which won't be implemented until April 2015, mean you won't have to withdraw the £25,000 tax-free lump sum in one go. Instead, you can take your tax-free money in separate tranches.

To see how this works, let's assume you still haven't touched your pension fund by April 2015, and you want to withdraw £10,000. You will be able to withdraw that sum as an Uncrystallised Pension Fund Lump Sum (UPFLS).

You'd receive £2,500 tax free and you'd have to pay income tax at your marginal rate for the remaining £7,500. So if you're already a higher-rate taxpayer, you'll have to pay 40% income tax on the remaining £7,500 in your lump sum.But if your overall income is smaller, you'll only have to pay 20% income tax or no tax in some circumstances.

This means that with careful planning, you could pay far less tax on your pension over your lifetime than under the current system.

What's more, if there is anything left in the pot when you die, your inheritors will be better protected from tax on the money you leave them.

If you die before you reach 75, they won't have to pay any income tax on the remaining funds they get from your pension. However, if you die at an older age, your beneficiaries will still have to pay some income tax when they withdraw cash.

The flexibility that new retirees are now gaining is very welcome. Let's just hope that everybody can resist the temptation to blow their pension pots in a hurry.