How are pension withdrawals to fund care home fees taxed?

I have a defined contribution pension pot which remains invested.

If I have to go into a care home at the end of my life and this pension pot is my only financial asset, I presume that the pension will be used to fund my care.

In this case, if the care home fees are greater than £50,000 per year, will I have to pay a higher rate of tax when I draw down funds from my pension pot?

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Later life planning: Will pension withdrawals to fund £50k-a-year care home fees be taxed at the higher rate?

Steve Webb replies: As you may know, the rules around care funding are about to change, so it may be worth a quick reminder of the new rules before thinking through how you might fund your own care costs in later life.

Note that all the figures and comments in this column are for someone living in England. There are small variations for people in Wales and a much more generous system for those in Scotland.

At present, if you go into a care home, and if your local authority agrees that you need that level of care, there will be an assessment of your regular income and of your capital.

On income, the council will expect you to use your own resources such as state pensions, private pensions and so on, to pay care costs but if your income doesn’t cover the full cost they will generally pay the difference.

They will also make sure that you have a modest amount left (currently £24.90 per week) to cover personal expenses.

On capital, any savings below £14,250 are ignored. If you have between £14,250 and £23,250 they will assume an amount of income you could be deriving from this capital and will reduce the amount of support by this amount each week.

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But if you have more than £23,250 you will be disqualified from any support.

Under the proposed reforms the main changes are:

– The amount of capital which is completely ignored will rise from £14,250 to £20,000

– The capital limit above which no help is available will rise from £20,000 to £100,000; but income will continue to be ‘imputed’ on capital between £20,000 and £100,000, so those with relatively large amounts of capital will get a lot less help each week than those with less capital

– There will be a new lifetime limit of £86,000 on social care, above which further costs will be covered by the Government

You can read more about these changes here. 

Turning now to your situation, you envisage a situation where you go into a care home and have to pay your own fees.

I am assuming that you took your tax-free lump sum in one go at retirement so all of the money left in your pension pot is potentially taxable when you access it.

In principle, if you took money out of your pension pot each month to pay for your care home fees, these withdrawals would be taxed in the same way as any other withdrawals.

You are likely to be in receipt of a state pension at this point, so your state pension plus any lump sum pension withdrawals would all count towards your taxable income for the year.

If the total amount exceeded the starting point for higher rate tax – currently £50,000 – then any excess would indeed be charged at 40 per cent, even though you are spending the money on care costs.

Given the size of assets we are talking about here, I would strongly encourage you to take early financial advice about your options.

Although care funding is a complex matter, some financial advisers specialise in this area, including some who are members of the Society of Later Life Advisers. 

Whilst you have to be very careful about doing anything artificial purely to maximise potential help with care costs, there are complex decisions to be made.

In particular, an adviser could consider whether your money is better left in your pension pot in case it is needed for later care costs or whether it could be more efficiently used in some other way.

It might also be worth being aware of a financial product called an ‘immediate needs annuity’.

This is bought at the point of entry to residential care. You hand over substantial one-off lump sum to the insurer and in return they guarantee to pay your care costs for as long as you live.

Although any money you take out of your pension pot to buy this product would be taxed as described above, you would then have the reassurance that your future care needs were covered.

This post first appeared on Dailymail.co.uk