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Question: I’m 62 years old and have worked in the public sector for about 21 years. Before that I invested some earnings in a defined contribution pension, which is currently worth about £53,000. I no longer contribute to this pension. I’m fortunate to be able to add some earnings into an additional voluntary contribution (AVC) through my workplace pension, thus reducing my monthly income tax liability and increasing my tax-free lump sum for when I retire in the next two years or so. I earn just under £60,000 per year.
Would it be a good idea to put as much in my AVC as I can to reduce my salary below the tax threshold and put my defined contribution pension into drawdown? I want to keep my income tax bills as low as possible when working and increase my available tax-free cash.
Answer: Given your career has been in the public sector, I’m going to assume you have built up a defined benefit (DB) pension during this period, with your defined contribution (DC) pension sitting alongside. For those unfamiliar with the terminology, a DB pension is one where you are promised a pension income based on your salary (either career average or final) and the number of years you have been a member of the scheme, with your pension paid from your “normal retirement age” (often, but not always, linked to the state pension age).
A DC pension, by contrast, is a pot of money invested that you can use to deliver an income in retirement, which you are able to access flexibly from age 55 (rising to 57 in 2028). This flexibility comes with extra risk, as your fund might not last throughout retirement if you draw it out too quickly, whereas a DB pension should be paid until you die.
Automatic enrolment rules require all employers to offer eligible staff a pension scheme that meets certain minimum standards, including minimum contribution rates and, where the scheme is DC, a “default” investment fund with charges capped at 0.75 per cent.
Both DB and DC pensions come with the incentive of upfront tax relief on contributions and the opportunity to receive a tax-free lump sum when you access your money.
In a DB pension, the available lump sum is at the discretion of the scheme and you may have to forgo some of your promised pension income to receive it. In DC, your tax-free cash entitlement is usually a quarter (25 per cent) of the value of your pot when you choose to access it. In most circumstances, the maximum tax-free cash you can receive over your lifetime is capped at £268,275.
What is an AVC?
The acronym “AVC” stands for “additional voluntary contribution”. This is just the name given to a pension scheme an employer offers to staff alongside its main pension scheme that they can voluntarily make extra contributions to.
An AVC scheme is most commonly, but not always, a DC scheme. Your employer may offer to pay into an AVC in the same way as they do your auto-enrolment scheme, although they are under no obligation to do this. Contributions to an AVC will benefit from the same tax advantages as contributions to a standard workplace pension scheme.
As you note, one of the benefits of saving in a pension is that you get tax relief at your marginal rate, effectively reducing your income tax bill at the same time as you save for retirement. If your employer allows salary sacrifice pension contributions, you could also lower your national insurance contributions, although make sure you’ve checked whether this will have any negative impacts, such as affecting your ability to borrow money or entitlement to maternity pay, before going ahead.
Provided you haven’t used up your tax-free cash entitlement, saving in your AVC scheme should boost the value of that pension, including any associated tax-free cash. If your AVC is a DC scheme, you’ll need to choose a retirement income route, such as drawdown, in order to access your tax-free cash (although there is no obligation on you to take any taxable income from your fund).
If you want to take a bit of tax-free cash but not your full entitlement, you can choose to put just a portion of your pot into drawdown. This has the benefit of allowing the rest of your pot, including the attached tax-free cash entitlement, to remain invested and potentially grow over the long term.
Unfortunately, I can’t tell you whether this would be a “good idea” or not, as this would constitute regulated financial advice. If you are considering taking regulated advice, you can find a local adviser using the Moneyhelper directory: Retirement Adviser Directory | Find a regulated financial adviser | MoneyHelper.