The over-55s have been liberated to make withdrawals from their pension pots but need to use their freedoms wisely or risk getting hit with a shock tax bill from HM Revenue & Customs.
While the first 25 percent can be taken tax free, the remaining 75 percent of money withdrawn may be subject to income tax.
Savers who can’t wait to get their hands on their pension and withdraw their entire pot in one go risk being pushed into a higher tax bracket for that year, and handing over a potentially huge sum to HMRC.
Dean Butler, managing director for customer at Standard Life, said pensions are a highly tax-efficient way to save so don’t throw money away right at the end.
“How much tax you pay on withdrawals depends on how and when you take the money, and there are several different ways to reduce your exposure.”
Since 2015, savers can normally access their pension from age 55, which is set to rise to 57 from April 2028 to keep up with state pension age increases.
After taking the tax-free cash, further pension withdrawals are added to all your other income sources for the year. This includes any state pension, work earnings, money taken from other savings, investments or annuities, and even certain state benefits.
It all needs to be carefully added up.
The full new state pension of £10,600 this year is below the £12,570 personal allowance, but even relatively small pension withdrawals on top could push people over, with the tax deducted from workplace or personal pension withdrawals rather than the state pension itself.
If a pension withdrawal pushes an over-55’s income above the personal allowance, it would be subject to basic rate income tax at 20 percent, minus the tax-free cash element.
Those who cash in big pots in one go could end up paying higher rate tax, which could see some of the money taxed at 40 percent or even 45 percent.
In some cases, this could be the only year of their life they fall into a higher tax bracket, causing huge regret. Especially if in future years they are nowhere near paying higher-rate tax.
Butler said many pension savers don’t realise the danger as they race to cash in pension and a lot is at stake as that money has taken a whole working lifetime to build. If at risk, it might be better to make smaller, regular withdrawals over a number of years.
Staggering pension withdrawals could save a lot of tax, and makes particular sense to someone who has a decent level of income from other sources, including a well-paid job.
Over-55s who need to generate large sums now, say, to clear a mortgage or other debts, could first withdraw any savings or investments they hold in a cash Isa or stocks and shares Isa, as all withdrawals are entirely free of income tax.
The over-55s should be wary of withdrawing too much money to soon, as they may run out of retirement savings in later life.
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Growing numbers prefer to leave their money invested inside a pension, as this can be passed on to loved ones free of inheritance tax on death, which is something else to consider.
Beneficiaries can inherit your unused pension pot entirely free of tax if you die before age 75, thereafter they will pay income tax on the money.
Another danger with taking a pension lump sum is that you could be overtaxed under an emergency code, said Tom Selby, head of retirement policy at AJ Bell.
HMRC treats a one-off withdrawal as if you are going to carry on taking that sum every month for the rest of the tax year, he said. “Many don’t realise the danger until they receive a sudden tax bill.”
You can get a rebate in 30 days by filling out one of three HMRC forms, or wait for HMRC to put things right at the end of the tax year, Selby added.
Canada Life technical director Andrew Tully suggested that someone making their first pension withdrawal should start by taking a small sum of, say, £100. “That will generate a tax code from HMRC which will apply to any subsequent withdrawals.”
Pension withdrawals are complicated with large sums at stake, so consider taking independent financial advice or speaking to free government guidance service Pension Wise.
