Annuity still best option for income

If income is a priority it will be difficult to match the guaranteed income from a retirement annuity. For a person aged 65 the 6% per year annuity income is currently twice the level of the possible 3% interest from bank and savings alternatives.

The following chart shows the effect of tax for a pension fund of £50,000 after tax free cash of £16,666.67 is taken.

Fig 1: Chart comparing tax treatment of pension fund

Any funds removed from the pension environment are likely to be taxed as only the first £10,000 allowance of annual income is free from tax free. Many people will also receive the state pension and other pension income could absorb this amount.

The next £31,865 is at basic rate tax of 20% and thereafter higher rate tax at 40% applies. From the £50,000 basic rate tax would reduce the fund to £40,000 and higher rate tax on the full fund would reduce this to £30,000.

To avoid higher rate tax, the £50,000 fund would need to be split across two tax years. As the new rules would be introduced from April 2015 this would mean using the tax years 2015/16 and 2016/17 to avoid paying higher rate tax on this fund.

The following chart shows the income received after the payment of either basic rate or higher rate tax.

Fig 2: Chart comparing net yearly income after marginal tax

For basic rate tax payers, the £50,000 fund for the annuity would provide a 6% gross income or £3,000 pa based on a single life, level annuity and after 20% tax this would reduce to £2,400 pa. If the fund was removed as a cash fund with basic rate tax paid, the £40,000 fund could receive interest from a bank of about 3% gross or £1,200 pa and after 20% tax this would reduce to £960 pa.

For a 40% higher rate taxpayer the net income for the annuity would be £1,800 pa. If the fund was removed as a cash fund with higher rate tax paid, the £30,000 fund could receive interest from a bank of about £540 pa.

The annuity still provides significantly more guaranteed income than removing the fund from the pension environment where interest from a bank is lower and may have to be sourced every year to find the next best interest rate provider.