By Jonathan Watts-Lay.
Changes in pension legislation have created a new era of freedom and choice for defined contribution (DC) pension savers. However with choice comes responsibility and the real possibility of making some huge mistakes. Here are some of the decisions people are making, which might not be the best choice for them. It pays to really think it through and know all the options. Here’s a look at what may seem like good ideas but probably are not.
Things NOT to do with your pension pot
- Cash is not king – Some people are taking cash out of their pension, not to spend it in retirement, but to put it into a bank account.
‘Cash Carol’ believes that cash is safe and that cash is king. She withdrew £10,000 cash from her pension in April 2015, not to spend, but to keep in a bank account. After paying basic rate tax on the withdrawalshe was left with £8,500 which she invested in a deposit account earning 2% interest. Over time, even if interest rates are more than inflation, it would take a substantial time to recover the tax paid. However, if inflation is more than the rate of interest then Carol’s cash will lose yet more value.
If individuals prefer to hold some cash, then they could consider switching part of their pension funds into cash, but still keep it in the pension wrapper so it keeps its tax free status. Then they can always switch the cash value to other investments in the future, and still benefit from the tax free growth and inheritance tax benefits of a pension.
- Withdrawing to reinvest – Some people are taking money out of their pension and reinvesting it in shares.
‘Investing Ian’ wants to buy a portfolio of shares, so he cashed in his pension to do this. Over the years the value of his shares has grown and he now is looking to sell. If the gain is more than the Capital Gains Tax allowance he will be subject to tax. He did not realise that he could have kept his money in his pension and just change what it is invested in, meaning that any growth in value would continue to be tax free and outside of his estate.
If individuals want to invest in different equities to those offered by their current pension provider, then they could consider switching to another provider which offers the choice they are looking for. A regulated financial adviser can help with decisions like this.
- Withdrawing when other taxable assets are available – Some people are taking income from their pension when they have other assets which are not growing tax free and are liable for income tax and inheritance tax, which they could be using instead.
‘Portfolio Paul’ has a range of pensions and investments. He has started to withdraw income from his DC pension, but does not realise that he might be better off living off his other taxable assets like taxable deposits (cash) and dividends, whilst his DC pension continues to grow in its tax efficient wrapper until needed.
For many, retirement income is not just about pension savings but all assets, such as ISAs and shares. This new retirement world is about looking at all assets to provide a retirement income in a tax efficient way.
- Don’t forget income tax – Pension income is subject to income tax whether individuals are working or not.
‘Working Wendy’ earns £19,000 a year and pays tax at 20%. She decides to cash in her £10,000 pension pot, but has not realised that only 25% of the pot is tax free. The rest, £7,500, is actually counted as income, increasing her income to £26,500, so 20% income tax is due. Instead of £10,000, she actually gets only £8,500 from her pension, as £1,500 is paid in tax.
When it comes to income taxes, many people think only of the money they earn in their payslip. It is important to account for all taxable sources of income and this can include income from pensions, savings and investments.
- Accidental high rate taxpayer – Some people are taking all the cash out of their pension in one go, and in some cases those that have never been a high rate tax payer, are suddenly finding themselves paying 40% tax.
‘Forty percent Phil’ is earning £38,000 and normally pays income tax of 20%. He has a DC pot of £42,000 and decides he wants to cash it all in. 25% of it (£10,500) is tax free. However, tax is due on the remaining £31,500 and as this is added to his earnings, it takes him into the higher rate tax bracket of 40%. He will be taxed as if he has earned £69,500. £5,000 of the pension pot would be taxed at the 20% rate and a whopping £26,500 at the higher rate of 40%, making a tax payment of £11,600 on his pension.
It’s important to remember income tax when withdrawing money from your pension pot. Phil could have withdrawn his money over a number of years, keeping the withdrawals below the 40% bracket, and saved himself £5,300 in unnecessary tax. He could also look at ways of paying the lowest amount of possible tax by considering how he could utilise all his assets (pension and non-pension) to make the best use of all available tax allowances.
Like any investment, pensions are subject to market conditions, but the general rule is that if you don’t need your pension money now, keep it in its pension wrapper so it can continue to grow tax free and benefit from the inheritance tax protection. There’s a concern that without the necessary financial education and advice, too many mistakes are being made which have long term consequences. Everyone withdrawing money from their pension should consider if they are a Forty percent Phil, a Cash Carol, or an Investing Ian, and to do some research to see what other options are open to them. Poor decisions which result in more tax being paid than is necessary ultimately means less money at retirement – clearly people would not do this if they understood the implications. If they are not sure about the decisions they are facing then they may want to consider taking regulated advice.
 25% of the withdrawal of £10,000 is tax free, the balance is subject to 20% income tax. 20% * £7,500 = £1,500 tax. Net amount received is £10,000 – £1,500 = £8,500
This article originally appeared on WEALTH at work.
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Jonathan Watts-Lay is a founding Director of WEALTH at work, a provider of financial education, guidance and advice in the workplace, working with a number of the UK’s leading companies to help employees understand their financial benefits. Jonathan’s latest development is a service for employers and employees which responds to the new pensions rules that came into force in April 2015.