Five ways to avoid costly pension tax mistakes
1) Cash is not king
Some over 55s are withdrawing cash from their pension to put it into a bank account.
Jonathan Watts-Lay of financial education and advice firm WEALTH at work gives an example of a saver withdrawing £10,000 cash from her pension to keep in a bank account. A quarter of this sum is tax free, so after paying basic rate tax on the remaining £7,500, she’d be left with £8,500. Even if interest rates were to rise, Watts-Lay said it would take a “substantial time” to recover the tax paid.
If you prefer to hold some cash, Watts-Lay said you could consider switching part of your pension fund into cash, but still keep it in the pension wrapper so it keeps its tax free status. That way you can 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.
2) Withdrawing to reinvest
Some over 55s are taking money out of their pension and reinvesting it in shares. However, a problem arises if the retiree who cashes in his pension to buy a portfolio of shares sees the value of the shares has grown and sells. If the gain is more than the Capital Gains Tax allowance (£11,100) he’ll be subject to tax. Any growth in his pension pot value, on the other hand, would continue to be tax-free.
Watts-Lay said that if you want to invest in different equities to those offered by your current pension provider, you could consider switching to another provider. He said that a regulated financial adviser may be able to help you decide whether this is best for you.
3) Withdrawing when other taxable assets are available
Some over 55s 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.
As an example, Watts-Lay said that a saver with a range of pensions and investments who started to withdraw an income may not realise he may be better off living off his other taxable assets like taxable deposits (cash) and dividends, while his Defined Contribution pension continues to grow in its tax efficient wrapper until needed.
4) Forgetting about income tax
Pension income is subject to income tax whether individuals are working or not. An employee earning £19,000 a year paying tax at 20% decides to cash in her £10,000 pension pot. But she doesn’t realise that only 25% of the pot is tax free while the rest – £7,500 – is counted as income (£26,500). Instead of receiving £10,000, she actually gets £8,500 from her pension, as £1,500 is paid in tax.
Watts-Lay said that when it comes to income taxes, many think only of the money they see on their payslip. “It is important to account for all taxable sources of income and this can include income from pensions, savings and investments,” he said.
5) Accidentally becoming a high rate taxpayer
Some over 55s 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.
A saver earning £38,000 usually pays 20% income tax. With a pension pot of £42,000, he decides to cash it all in. 25% of it (£10,500) is tax free but 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%. Watts-Lay said he’ll 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.
Watts-Lay said it’s important to remember income tax when withdrawing money from a pension. “The employee 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.”