30th March 2015 at 7:48am
There’s a lot of positive talk about the new pension rules and the fresh flexibility they’ll bring in retirement. But there’s also a degree of concern that the option of unrestricted access to a lifetime’s pension savings could be a temptation too far for some.
Stop and think
At retirement it’s important that your focus shifts from building your pension pot to how you’re going to take your money, make your income last throughout retirement and provide the greatest inheritance for future generations. To make that money last, it’s important to choose to take your income in a way that not only suits your day-to-day needs but is also tax efficient.
It’s important to choose to take your income in a way that not only suits your day-to-day needs but is also tax efficient.
New rules mean that from 6 April 2015 you’ll have the option to take the whole amount as cash if you want to. And you’ll normally be able to get up to 25% of this free of tax. Generally, any other cash you take out will be paid to you after income tax has been taken off and how much this is will depend on the total amount of income you’re getting. This could be coming from various places including your pension, savings and investments.
However, it’s important to understand that if you were to take your pension fund in one lump sum you could be hit with an entire retirement’s worth of income tax liability in a single tax year. It also means you could be wasting valuable tax allowances and could end up with an income tax bill which is potentially higher than the tax relief you enjoyed when making your contributions. Plus you may be eligible for Inheritance Tax (IHT) too, as when you take your money out of your pension it sits within your estate – so it could mean another 40% IHT is due (if you own assets of more than £325,000).
Drip feed your finances
A tax-efficient way of making your money last longer could be to draw your pension in stages, particularly if you choose an option known as income drawdown. It‘s the main alternative to an annuity (where you exchange your pension for a secure income for life). Drawdown allows you to draw the money you need directly from your pension, and keep the remainder invested and under your control. You’ll be able to dip in and make as many withdrawals as you want, each time getting 25 per cent tax-free (assuming you’ve not already taken your tax free cash) with the rest taxed as income.
Providing you get your investment decisions right, whatever you haven’t spent could still be growing, but it’s always worth remembering there’s a chance it could drop too. And if there is anything left over when you die, recent tax changes make it easier to leave funds to your loved ones and pass your wealth on.
How it could pan out
Here’s an example. Let’s say you’ve built up a pension pot of £100,000. If you were to take it out in one go in 2015 you’ll be hit with tax of £19,403, that’s if you’ve no other income, otherwise the bill will be higher. It also means IHT of 40% could be due on death. If withdrawals are spread over five years that tax falls to £4,400 in total, again this takes into
account you’ve no other income. And if spread over ten years, it can all be taken out free of tax.
The tax factor
Tax will always be a fact of life whatever stage you’re at. However the new pension rules have been designed to give you options not enjoyed by past generations. It’s well worth taking stock and looking at what might be the most tax-efficient option not only for you but for any legacy you hope to leave behind too. The choice is now yours.
This article is not financial advice. A pension is an investment. Its value can go up and down and it may be worth less than you paid in. Laws and tax rules can change in the future. This reflects our understanding at February 2015.