Aged 55 or over? Questions you should ask before accessing your pension
Since 2015, the landmark pension freedoms rules have given pension savers aged 55+ access to as much of their pots as they want or need.
The first 25% withdrawal is tax-free while the remaining 75% is subject to the individual’s marginal rate of income tax.
With the current coronavirus pandemic putting a strain on finances, those approaching retirement may be tempted to dip into their pension savings to cover short-term costs.
Steven Cameron, pensions director at Aegon, said: “Those over 55 considering accessing money from their pension should think carefully about whether they’ve explored all of the other options available. Just because you can access your pension savings, doesn’t mean you should. You should also make sure you are claiming any government support you may be entitled to during this crisis.
“While defined contribution pensions now offer significant flexibility on what can be taken when, there can be many tax consequences both now and in future. Pensions are designed to provide you with an income throughout your retirement and taking out more money than you need to, or starting sooner, will mean you have less to live off in future.
“Before coming to a decision it’s wise to consider all your options and for this we recommend you seek personalised advice from a professional adviser. Alternatively, you can get help from the government’s impartial guidance services, Pension Wise or the Money Advice Service.”
However, Cameron sets out four initial questions to ask yourself before contemplating accessing your life savings:
Can you use other savings ahead of pensions?
Your defined contribution pension is likely to be invested at least partly in stocks and shares, which have recently seen a significant fall in value. Taking money out in the current market downfall means the money you withdraw doesn’t have the chance to recover its value if stock markets then recover.
Before looking to your pension for extra support in the short-term, consider using any cash savings first to tide you over for now. Further, you should also try to keep some ‘rainy day’ savings in cash.
Are you taking more money than you actually need?
If you do need to withdraw money from your pension, ask yourself how much you actually need right now. The more you take out now after stock markets have fallen, the less will be left in your pension to gain from any future market rises.
When you start taking an income from your pension, you can usually take up to 25% of your fund as a tax-free lump sum. But you can take out funds from your pension in stages so avoid taking out more than you need. This means you may be able to take a smaller tax-free lump sum now and further tax-free entitlements later through your retirement. You should seek advice on what your provider offers and the best course of action to suit your own circumstances, however.
Do you know how much income tax you’ll pay?
Pensions usually allow you to take 25% of your pot tax-free. The rest will be taxed as income when it’s withdrawn, at your ‘highest marginal rate’ at that time. This could mean you pay 20%, 40% or even 45% on such income if you are a UK taxpayer or 21%, 41% or 46% if you are a Scottish taxpayer.
Crucially, if you take out a large amount of your pension in a tax year – or even cash in the whole pot – this could push you into a higher tax bracket, resulting in you paying more tax than you would have if you’d taken smaller amounts out over a longer time period.
Another point to note is that when you first take an income (other than a tax-free lump sum) from your pension pot, HMRC requires your pension provider to deduct income tax.
Usually, HMRC makes an assumption that the amount you first take is what you plan to take every month. So if you take £5,000, they’ll tax you as if you are taking £60,000 a year which would mean you would pay higher rate tax even if you have no other income.
If you don’t actually take this every month, and are a basic rate taxpayer, you can claim the extra tax back, either by filling out an HMRC repayment form or waiting until the end of the tax year, when HMRC will refund any overpayment.
Will you want to continue paying into your pension in the future?
If you decide to take money over and above the tax-free limit, you could be limited in how much you and an employer are allowed to contribute in the future. Under the Money Purchase Annual Allowance, contributions from you and your employer can’t exceed £4,000 a year without facing heavy penalties.
This may seem like a problem for another day, but it might affect what you want to do in future to rebuild your pension and get your retirement savings back on track following the big dent to investments due to Covid-19.