On 6 April – Easter Monday – freedom begins. If you are aged 55 or more money you have saved up in a pension fund over a lifetime can be taken out and spent. But think carefully before giving in to temptation.
What are the tax implications of accessing your pension pot?
First, you won’t keep it all. If you take out your pension pot in full, a quarter of it is tax-free but the rest is added to your income in the year you take it and taxed.
So even a modest pension pot – the average is £34,000 – can push your income into higher rate (40%) tax which begins at an annual income of £42,385. A big pension pot could be taxed even more if it pushed your income over £100,000.
At best you will normally lose 15% of your total pot to tax and in many cases that will be up to 30%. So you may only get £35,000 out of a pot worth £50,000.
To avoid paying higher rate tax, it may be worth considering taking out your money over several tax years to keep your annual income below the higher rate threshold. Remember, if your total annual income is less than £10,600 no tax is due.
Revenue rules mean the pension provider has to tax the pension money as if you received that income every month of the tax year, even if it is a one-off payment. So you could find a deduction of as much of 40% off the total. If that is more tax than is due – it usually will be – you will have to claim the overpaid tax back from HMRC either on a form called a P53 or wait until the end of the year and do it through your self-assessment.
Confused by pensions? Read our jargon buster
Don’t forget to calculate how long your pension pot will last you
Of course, none of us knows when we are going to die. It depends on our sex, health, lifestyle, and postcode. But, in general, at 65 men can expect just over 20 years and women a bit longer. More than one in ten of today’s 65 year olds will live to 100. So planning for 25 years and thinking about 35 is probably sensible.
If you have a pension pot and take it out in cash and have £50,000 left, then simple arithmetic says that is going to provide only £2000 a year over 25 years. If the money earns 2% and you take out £2000 a year, then it will last until you are 100 or you could take out £2500 a year and it would last 25 years.
If it earns 5% a year, you could take £3500 a year over that time. Beware any investment that promises more than 6% a year or says the return is guaranteed. Refuse any investments offered by cold calls or emails. Assume they are scams.
If you put your cash in a savings account, you can take the money out as and when you need it. Withdrawals will not be taxed (though interest earned may be taxed if it is more than £1000 per year) because tax will have been taken already. Remember that at 85 your needs may be very different from those at 65.
How much money will you need in retirement?
Look at all of your sources of income
Consider what other income you have in retirement. Have you got another pension from a job? How much will your state pension be? Do you have several pension pots? If you do, then you can make different decisions about each.
Perhaps taking some as cash now – less the tax, of course – keeping others for later or converting one or more into a guaranteed income for life. So before you consider what to do, make sure you have found all your pensions. The free Pension Tracing Service will help you track down company and personal pensions.
You may want to convert one or more of your pots into an annuity – a guaranteed income for life. Some pensions, usually started before the mid 1990s, come with what is called a Guaranteed Annuity Rate or GAR. That means the terms of the contract give you a much better annuity than you could buy today.
Now, even a £100,000 pension pot would only get you around £5500 a year. A GAR could be double that. So never move your money from a pension with a GAR without giving it a lot of thought. If you want your income to rise with inflation, you will get little more than half those amounts in the first year and it could take 25 years to reach the amount you could get on a flat annuity.
Read our guide to the different types of pension.
Consider all the alternatives before cashing in your pension
You do not have to cash in a pension or convert it into an annuity. You can put it into a drawdown plan instead. The money is invested for you and there will be charges taken out each year. You should be able to take out variable amounts as and when you wish, though any withdrawals will be added to your income and taxed. So it is best to take out your 25% tax-free lump-sum before going for drawdown.
There is a new way of taking money out of your pension under the odd title Uncrystallised Funds Pension Lump Sum (UFPLS). You just leave your money in the pension fund itself and take out bits as and when you want – either as one-off payments or regularly. The first quarter of each withdrawal will normally be tax free. The balance will be added to your income and taxed.
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The new rules give everyone over the age of 55 great freedom to do what they like with their pension fund. But they do not compel pension providers or financial firms to implement them.
You may find your provider says you cannot do things or wants to charge you for doing them. That will be especially true in the early months after the rules start. In some cases you may have to move your pension fund to another firm which is more amenable and there may be charges to pay at one or both ends of the deal.
The new rules apply to money saved up in what is called a defined contribution or money purchase or personal pension. Pensions from your job that are linked to your salary – called defined benefit pensions – are not part of the new scheme.
If you work in the private sector, you can convert these pensions into a pension pot. In the public sector you generally cannot. If you want to do that and the pension is worth more than £30,000, you will have to take professional financial advice.
If you get a means-tested benefit, such as pension credit, jobseekers allowance or housing benefit, any money taken out of a pension could mean you get less. The rules are complex and different for each benefit. But taking income or a lump-sum could cut your benefit, making it less worthwhile to take the pension.
Paul Lewis writes a column in Saga Magazine.