Why you shouldn’t withdraw your entire pension in one go
Personal pension investors aged 55 and over have more freedom to access their money than ever before. You can still typically take up to 25% of your pension as a lump sum tax free, with the rest as taxable income, but thanks to fresh rules that started in April this year, you can now receive the whole lot as a lump sum.
But there are some very good reasons why in most cases you wouldn’t want to do so…
- A substantial tax bill
25% of a lump sum payment is typically tax-free, but the rest is taxable income. This is particularly relevant for those still working. For instance, someone earning £45,000 a year and taking £20,000 from a pension pot (allowing for the 25% paid tax-free) would have to pay a whopping £6,000 in tax. In some cases it also can push individuals into a higher rate of tax. Even people with modest pension pots should think very carefully about the tax consequences before opting to cash them in – and seek guidance or, if in any doubt, financial advice before doing so.
- Tax can get complicated
What sounds like a simple process can become complicated. If you elect to take the whole of your pension in one go, and your provider has no official record of your tax coding, they will use an emergency tax code which could result in you paying more tax than you owe. This excess tax can usually be claimed back, but it could be an inconvenience.
- You could run out of money
Another factor, perhaps equally important as tax, is the risk of running out of money. The main aim of a pension is to support you in retirement, and the traditional means is by buying an annuity, which provides a guaranteed income for life. Annuities have previously come under much criticism for being poor value with limited death benefits. Yet guaranteed annuities remain a very good way of providing an income that is guaranteed for life that involves no investment risk.
Before opting to draw a lump sum it is important to be aware of what the most competitive pension annuities could give you instead. This means shopping around and getting quotes. If you have existing health conditions or are a smoker you could get an enhanced annuity rate.
- Death benefits
Before April 2015, having taken tax-free cash or an income or after age 75, lump sum death benefits were taxed at up to 55%. There was therefore little incentive for people to keep hold of pension funds over other assets, which, if an individual’s estate value of more than £325,000, were typically taxed at 40% inheritance tax.
Now, on death before age 75, remaining pension funds can typically be paid to nominated beneficiaries free from tax, and they can withdraw money as income tax free too. On death after age 75, pension payments to dependants and nominated beneficiaries will be taxed at their income tax rate and lump sums at a special rate of 45%. Where ownership of the pension passes to a beneficiary with no funds drawn, there is still usually no tax, but beneficiaries that inherit the pension are charged their marginal rate of income tax on pension withdrawals they make. Money purchase pensions could therefore now represent a way of passing on death benefits efficiently, another aspect to consider before reducing the value of your pensions through withdrawals.
Taking guidance or advice
Misunderstanding the tax consequences of taking lump sum benefits from your pension can be cost you unnecessary tax, or result in taking a course of action inappropriate for your attitude to risk. Retirement options include drawdown, uncrystallised fund pension lump sums and annuities, and the methods, or combination of methods, used can make a major difference to how much tax is paid and, ultimately, how much you receive. There are many different strategies, and it is vital to make appropriate decisions at the outset.
There are a number of free sources of guidance on pensions, such as Pension Wise and The Pensions Advisory Service. Taking regulated financial advice may also be helpful, particularly for more complex decisions. A financial adviser will be able to help explain the options available and recommend the most suitable way to achieve your retirement goals.
Rob Morgan is pensions & investments analyst at Charles Stanley