Five things NOT to do with your pension
However, while you may not be planning to blow your savings on a sports car or an expensive cruise habit, it’s easy to make costly mistakes even when you have the best intentions.
Make sure you don’t wipe thousands off your pension with our guide.
1. Cash is not king. “Some people are taking cash out of their pension, not to spend in retirement, but to put in a bank account,” says Jonathan Watts Lay, a director at Wealth at Work. “People do have a lack of trust in pensions and see getting money out as a good thing. However, it may not make any financial sense.”
Example: ‘Cash Carol’
Carol regards cash as a safe investment. So following the pension freedoms in April 2015 she withdrew £10,000 – not to spend, but to deposit in an instant access account to have on hand for emergencies. However, only the first 25% was paid tax-free and after basic rate tax was deducted from the remainder she only had £8,500 to pay into her account. With the top-paying instant access account paying less than 1.5%, it would take a serious amount of time to recover the money lost to tax. Throw in inflation and she may lose more money in real terms.
- Read more about the taxes you pay in Moneywise’s tax rates round up.
Mr Watts Lay adds: “If individuals prefer to hold some cash they could consider switching part of their pension fund into cash but still keep it in the pension wrapper so it keeps its tax-free status.”
2. Withdrawing to invest: Wealth at Work has also noticed a desire for eager investors to cash in their pensions and reinvest the money in shares. This does not make sense for two important reasons. Firstly, 75% of the withdrawal will be taxed at your highest rate of income tax and second, you lose protection from income tax, capital gains tax and inheritance tax.
Example: ‘Investing Ian’
Ian wants to buy a portfolio of shares, so he cashes in his pension to do this. Over the years the value of his shares grows and he is now looking to sell. As his gains exceed the capital gains tax allowance he has another tax bill to pay (after paying income tax when he cashed his pension in). He was not aware that if he had kept his money in his pension, and reviewed where his money was invested, his money would have continued to grow tax-free and remain sheltered from IHT.
Mr Watts Lay says: “If individuals want to invest in different shares and investment funds to those offered by their current pension provider, then they could consider switching to another provider, which offers the choice they are looking for.” An eager investor, for example, could switch into an online self-invested personal pension (Sipp) that offers access to shares in addition to the full universe of investment funds. “A regulated financial adviser can help with decisions like this,” he adds.
- Read about how to find a financial adviser in 2016.
3) Withdrawing from a pension when more tax-efficient sources of income are available: When you have spent your working life saving into a pension it seems only natural that it’s your first port of call when you retire and need an income. However, the tax benefits of pensions (including tax free growth and protection from inheritance tax) mean it may make more sense to spend other less tax efficient assets first. “A pension is a great IHT planning tool,” says Mr Watts Lay. “If you die before 75 it is paid free of income tax as well as being free of IHT. If you die aged 75 or over it will only be taxed at your marginal rate.”
Example: ‘Portfolio Paul’:
Paul has a variety of pension and investment plans. When he retired he started taking money out of his defined contribution pension first, but does not realise that he might be better off living off his other taxable assets like cash deposits and dividends from shares, while his pension continues to grow in its tax efficient wrapper until needed.”
Likewise as income from pensions is taxable, you may find it makes sense to draw an income from any assets that pay a tax-free income first, such as individual savings accounts (Isas).
Mr Watts-Lay says: “For many, retirement income is not just about pension savings but all assets such as Isas and shares. This new retirement world is about looking at all assets to provide a retirement income in a tax-efficient way.
“The trick is using your personal allowance every year. So you might take up to your personal allowance [£11,000 in £2016/17] from taxable assets like pensions and then use tax free assets like Isas over and above that.”
This makes it possible to have an income in excess of the personal allowance and still pay no income tax.
4) Don’t ignore income tax: Income tax doesn’t just apply to earnings and will be payable when your overall income for the year exceeds the personal allowance of £11,000 (2016/17). If you make any lump sum withdrawals from your pension these will be added to your income for the year.
Example: Working Wendy:
Wendy earns £19,000 a year and is a basic rate taxpayer. She decides to cash in her £10,000 pension but does not realise that only the first 25% is paid tax-free. The remaining 75% - £7,500 – is counted as income and increases her overall income for the year to £26,500 and so 20% tax is applied to this total. This means that after withdrawing £10,000, £1,500 gets swallowed up by tax and she only gets £8,500.
Mr Watts Lay says: “When it comes to income taxes, many people think only of the money they earn in their payslip. It’s important to account for all taxable sources of income and this can include income from pensions, savings and investments.”
5) Don’t become an accidental higher rate taxpayer: Taking cash out of your pension will not only increase your tax bill, depending on how much you withdraw and your overall income, it may even push you into a higher rate tax bracket. This means that people who have paid basic rate tax throughout their working lives could become higher rate taxpayers overnight if they cash in, or take a lump sum out of their pension.
Example: 40% Phil
Phil earns £38,000 and pays basic rate income tax of 20%. He decides to cash in his £42,500 pension. The first 25% - so £10,500 – is paid tax free. However, he needs to pay tax on the remaining £31,500, which is added to his overall earnings for the year. This bumps him up into the higher rate tax bracket and he is taxed as if he has earned £69,500. £5,000 of his pot would be taxed at 20% and a whopping £26,500 at the higher rate of 40%, giving him a total tax bill of £11,600 on his pension and leaving him with a pension of £30,900.
Mr Watts Lay says: “It is important to remember income tax when withdrawing money from a pension. Phil could have withdrawn his money over a number of years, keeping withdrawals below the 40% bracket and saving himself £5,300 in unnecessary tax. He could also look at ways of paying the lowest amount of tax possible by considering how he could utilise all his assets to make the best use of all available tax allowances.”
*Example case studies provided by Wealth at Work.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
Defined contribution pension
Often referred to as a “money purchase” scheme, although offered by employers (who may pay a contribution) these pensions are more likely to be free-standing schemes that a person contributes to regardless of where they are employed. Here, the level of benefit is solely dependent on the accumulated value of the contributions and their performance as investments. Therefore, the scheme member is shouldering the risk of their pension, as the scheme will only pay a pension based on the contributions and investment performance. The final pension (minus an optional 25% that can be taken as tax-free cash) is then commonly used to purchase an annuity that would provide an income for life.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.