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Explained: How private pensions are changing

Today's announcement means a revolutionary change in the way that defined contribution pensions - the most popular private pension schemes in Britain - are accessed.

To put it simply, George Osborne has promised to remove all tax restrictions on how people with these schemes can access their pension pots.

This is how the pension system currently works for people with defined contribution schemes:

People with pension pots between £18,000 and £310,000 are often pushed into choosing annuities. Credit: HM Treasury

At present, people with pension pots between £18,000 and £310,000 have been constrained in the choices they have had for access to their retirement savings.

As the diagram shows, those with pension savings below the lower threshold (£18,000) have been allowed to withdraw all of the money without paying any tax beyond their marginal rate (eg, 20% for basic rate taxpayers or 40% for higher rate taxpayers).

Those with pension pots above the higher threshold (£310,000) also had flexibility, because they had the flexibility to draw down their pension - in other words, to take as much from it as they wanted on an annual basis.

However, those in the middle have often been forced into buying annuities as a result of tax restrictions (a 55% rate of tax for withdrawing more than a quarter as a lump sum or for breaching the drawdown limits).

An annuity is a scheme that pays out regular income based on the amount of your pension savings. Using this system hasn't been great for everyone as annuity rates have been low for some time.

So not only was the system a little complicated, but it's also been seen as unfair on those who've felt pushed into choosing an annuity, which may not be the most financially beneficial way of using their money.

Here is a diagram showing how the new system will work for everyone:

In the new system, the 55% tax rate is removed - meaning no restrictions on how a pension can be taken. Credit: HM Treasury

As you can see, the proposed new system is quite a bit simpler.

At the point of retirement, pensioners can now access their retirement savings however they wish - whether through full withdrawal, an annuity or drawdown - without the threat of a 55% tax rate.

So, for example, if you have a pension pot of £200,000 on retirement, you could take £50,000 tax-free as a lump sum, use another £50,000 to get a regular income through an annuity, and then drawdown as much as you wish or need from the remaining amount each year to supplement your income.

In addition to the above, there will also be a guarantee, enforced by law, that anyone reaching retirement age will be offered free, impartial, face-to-face advice on how to make the choices that are best for them.

All of these changes will be coming into effect once the government has managed to get them through Parliament.

In the meantime, a number of tax restrictions on pension drawdown have been loosened from 27 March:

  • The amount of annual income required in order to qualify for flexible drawdown will fall from £20,000 to £12,000
  • The capped drawdown limit will increase from 120% to 150%
  • The size of a single pension pot that can be taken as a lump sum will rise from £2,000 to £10,000
  • The overall size of pension savings that can be taken as a lump sum will increase from £18,000 (as shown in the diagram above) to £30,000

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