The changes to the pensions system announced in the Budget trumpeted a new era of freedom and choice for pension savers. However, with the full details of the pension changes still to be considered, Jonathan Watts-Lay highlights a few common pitfalls those approaching retirement should watch out for
1. Tax, tax, tax – when is £10,000 really only £8,500?
Until April, the new rules allow up to three pension pots worth £10,000 or less to be taken as a cash lump sum. While that sounds great, it is easy to forget that this is subject to income tax, so those that do cash in a £10,000 pension pot are unlikely to actually get a £10,000 cheque from their pension provider. Make sure you take this into account when budgeting for your retirement.
Example: Alan is 60 (the minimum age for taking a small pot as a lump sum) and earns £19,000 a year. He pays tax at 20%. Alan has a £10,000 pension pot and although he is not going to retire yet, the money will come in handy to pay for his daughter's wedding.
Alan thinks he will get the full £10,000, but he does not realise that only 25% of his pension pot is tax-free and the rest (£7,500 – even though it is paid as a lump sum) is actually counted as income and so, income tax applies.
Taking a cash lump sum from a pension pot may sound tempting, but if it isn't really needed, it is best to leave it alone
By taking his pension pot all in one go, Alan has actually increased his earnings for the year from £19,000 to £26,500. The income tax on the £7,500 is £1,500 at his marginal rate of 20% – this means that instead of getting £10,000, he will only get £8,500 for his daughter's wedding.
2. The accidental higher rate taxpayer
From April, there will not be a limit on how much anyone can take as a lump sum. Everyone over the age of 55 will be able to take their whole pot whenever they want, but many do not realise that income tax is payable on the majority of the pension pot.
This makes it possible for even those that have never been a high rate taxpayer to suddenly find themselves paying 40% tax.
Example: It is now April and Jackie, aged 60 and earning £38,000, is paying income tax at a rate of 20%. She has a direct contribution (DC) pension pot of £42,000 and wants to cash the whole fund in one go to buy her dream car.
The tax-free part is worth £10,500, which is 25% of her pot. The remaining £31,500, because it is paid as a lump sum, is added to her income for that year to work out her income tax. Jackie is now taxed as though she has earned £69,500, which means she will pay some income tax at 40% (the higher rate tax band).
In fact, £4,285 of her pension pot will be taxed at her 20% rate and a whopping £27,215 at the higher rate of 40%. This is £11,743 more than she was going to pay in income tax when just her salary of £38,000 was taken into account. She now has just £30,257 to buy her dream car and not the £42,000 that was in her pension pot.
Jackie can phase her withdrawals and avoid higher rate tax – our preferred method of withdrawing pension funds. The calculations that follow are based on expected 2015-16 tax rates and allowances:
• Personal allowance £10,500, first £31,785 at 20%; 40% above this up to £150,000 and 45% thereafter.
• On £38,000, she has £10,500 allowance, then £27,500 at 20% = £5,500 in tax.
• If she takes her pension pot, then £42,000 x 25% tax-free cash is £10,500, which leaves £30,500 to be added to her salary = £69,500.
• Tax is £10,500 at nil (personal allowance); next £31,785 at 20% = £6,357; next £27,215 at 40% = £10,886, which is £17,243 in total.
3. Keep tax-efficient savings tax-efficient
Taking a cash lump sum from a pension pot may sound tempting. But if it isn't really needed, it is best to leave it alone.
Pension pots grow in a very tax-advantaged way, with no tax on capital growth or additional tax on dividends.
As soon as the money is taken out of a pension wrapper, there are a range of taxes waiting to get a share of the cash (such as inheritance tax, capital gains tax and income tax – depending what it is used for).
For many, rather than taking a pension lump sum, it can be better to live off their savings, leaving their pensions to grow in its tax-efficient wrapper.
This has the added bonus if they are still working. When they retire, there is a good chance they will be on a lower tax rate, so the income drawn from the pension will be taxed at a lower rate.
Example: Mike and June are both 63 and in defined benefit company pension schemes, where their pension is based on their salaries and length of service when they retire.
Their pensions will be index linked to protect against inflation and there are widow's and widower's pensions as well. They both have the option of a tax-free lump sum.
As well as their pensions, Mike and June have been careful savers and put the maximum amount into ISAs each year. Mike also had some savings in a DC pension scheme and it now has a value of £27,000.
Mike is in good health and is now thinking about what to do with his DC scheme. He is tempted by the prospect of being able to take it all as cash, but is aware that he will have to pay tax on 75% of the value of the pot and then, if he has no plans for it, there is a good chance it will just sit in a savings account and won't earn him a good return. That return will also be subject to savings tax at 20%.
If anything then happens to Mike, the value of the savings is added to his estate when working out whether inheritance tax applies. If he had left it in his pension, then this usually would not apply.
He therefore decides not to cash in his DC pension and instead Mike and June will live off their company pension schemes topped up with their ISA savings where necessary until they need to access their DC pension.
4. The risk of ruin
There has been a lot of press about pensioners blowing their pension savings, the now infamous buying of a Lamborghini, or turning into buy-to-let property magnates.
However, the "risk of ruin" (the American gambling term used to describe the risk of losing all of your savings) might actually be something a bit more mundane: the risk of underestimating just how long retirement might last.
Example: Stephen is 55 and expects to live until his mid-80s. Therefore, his pension will need to last 30 years or more. Without financial advice, many people do not know how to manage their money to achieve an income that will last this length of time. If he does spend it too soon, he will have to rely on the state pension.
5. Create your own ‘personal tax allowance'
The temptation to take pension savings as a cash lump sum is understandable. But to really maximise retirement income, it is important to consider all savings and investments, as well as the DC pension pot.
Think of them as being in one big retirement account that can be drawn from in the most tax-efficient way, taking what you need while minimising the tax you need to pay on your income.
Example: Jeff, aged 62, has a DC pension pot of £40,000. He has ISA savings of £30,000 and another £30,000 in a deposit account. He also has a company pension scheme which pays him an annual pension of £12,000.
He decides that he would like some extra income, so uses his deposit account to take regular lump sums instead of an income. He also tops this up by drawing a tax-free income from his ISAs.
Once his deposit account is empty, he then uses his ISA capital to do the same thing safe in the knowledge that whatever he takes out is free of tax. This gives him an extra income of £5,000 a year for about 12 years.
Once Jeff has used all of his ISA savings, he then turns to his DC pension and takes some of his tax-free lump sum to supplement his company pension scheme income, alongside his state pension.
This takes several years, at which point Jeff can then decide to carry on taking money out of his DC pension as an income or a lump sum or buying an annuity to give him an income for the rest of his life.
By using all of his savings as a retirement account and using the least tax-efficient first to create an 'income", Jeff can make sure that he has allowed himself the most tax-efficient personal allowance.
Jonathan Watts-Lay is director at WealthatWork
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