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Top five pension pitfalls

Jonathan Watts-Lay
Written By:
Jonathan Watts-Lay
Posted:
Updated:
10/12/2014

Pensioners will soon enjoy unprecedented access to their savings, but Jonathan Watts-Lay of WEALTH at work warns of five potential pitfalls.

From April 2015 restrictions on how you can access your defined contribution pension (DC) schemes disappear for anyone aged 55 or over.

At first glance this looks to be great news for those about to retire who thought that at best they’d have to buy a poor value annuity with their hard earned savings. However, there are some major pitfalls that anyone approaching retirement needs to be aware of.

Tax, tax, tax – when is £10,000 really only £8,500?

Until April 2015 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’s easy to forget that this is subject to income tax. Those that do cash a £10,000 pension pot in 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.

The accidental higher rate tax payer

From April 2015 there won’t 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 don’t 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 tax payer finding themselves paying 40 per cent tax.

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.

For many it can be better to live off their savings rather than taking a pension lump sum, thereby leaving their pensions to grow in its tax efficient wrapper. This has an 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.

The risk of ruin

There has been a lot of press about pensioners blowing their pension savings on 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.

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 one does spend it too soon, he or she will have to rely solely on the state pension.

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 whilst minimising the tax you need to pay on your income.

Jonathan Watts-Lay is director of WEALTH at work.