Five things to know before taking money out of your pension fund
From April, the chancellor wants you to be able to do what you like with your pension savings once you reach age 55.
Instead of the old draconian restrictions, the new rules mean if you want to spend your whole fund you can; if you want to take out a bit at a time, you can; if you want to use your pension fund like a bank account, you should be able to do so.
This is very exciting, but it's important to know what to watch out for. Here are a few things you should think about before you rush to cash in your pension fund.
1. 'Do nothing' option - just because you reach your scheme's pension age, you don't actually have to take money out at all
Many people have personal pension plans started in the 1980s or 1990s. Some may have 'additional voluntary contributions' (AVCs) that they saved alongside their employer's final salary-type pension scheme. When setting up these funds, they would have been asked to select a retirement date. All those years ago, early retirement was quite commonplace, and many chose age 60 or even 55.
About six months before the pension age originally selected, the pension company will send out a 'wake-up pack', consisting of reams of paperwork, offering an annuity and explaining that you can shop around for a better annuity or use income drawdown.
When you get this pack, you may think you have to do something with your fund, but actually that may not be the case. If you are still working, or if you have other pension income, you may benefit from leaving the fund alone to earn extra tax-free investment returns, rather than buying a product, or transferring or withdrawing the money.
Many people in the past have automatically assumed they need to buy an annuity or income drawdown product and, of course, the pension companies want to sell you a product, but don't be fooled into thinking you have to buy one. The 'do nothing' option may have merit, so take financial advice if you're not sure what's best.
2. Your pension provider may not allow you that flexibility - beware of hidden penalties
Although in theory you shouldn't have to do anything just because you reach your scheme's pension age, in practice I'm afraid some firms will fine you if you don't.
Under the terms of many old pension policies, you are penalised if you don't buy an annuity or income drawdown product on the date you originally selected as your pension age. Even if your plans have changed and you don't need your pension now, your pension company can charge you for not taking it.
Check your policy carefully to see if such penalties apply. If so, you might also want to see if you can move your fund to another firm that will let you continue to earn returns and have more flexibility (but there may be charges for that too).
3. Don't inadvertently overpay tax - check how much tax you will lose if you cash in your pension fund or take out a large amount
One of the most important things in the new pension world is to beware of inadvertently tipping yourself into top-rate tax. Any money that you withdraw from your pension fund (other than your tax-free lump sum) will be counted as income in the tax year that you take it.
For example, if you are still working or have other income of, say, £40,000 a year and you cash in a £40,000 pension fund, £10,000 will be tax free, but the remainder will be taxed.
You will have a total income of £70,000 in that year, which pushes you into the 40 per cent tax band, so much of your pension withdrawal will face 40 per cent tax even though your normal earnings would only be taxed at 20 per cent.
If you take £150,000 from a pension fund then you will push yourself into the 45 per cent tax bracket. It is essential that you are aware of the tax penalties you could face before you take the money out.
Bear in mind that if you delay taking your pension money until your other income falls, or if you plan to take out smaller sums at a time, the tax you pay should be much lower - and your money will benefit (hopefully) from extra tax-free investment returns.
4. All 'bank account-style' withdrawals will be part-taxed
From April, you will have the option of either taking your whole tax-free lump sum in one go and moving the remainder of your pension fund into an income drawdown account - called 'flexi-access drawdown' - or taking out a bit of your fund at a time.
The new rules will allow you to take out some money when you want to or make regular withdrawals, but these 'bank account-style' withdrawals will all be part-taxed. The technical term for each withdrawal is 'uncrystallised pension fund lump sum (UFPLS)'.
We do not yet know which pension companies will allow you to take these withdrawals or how they will operate - but while one quarter of each withdrawal could be tax-free, the remainder will be subject to tax and added to your other income to determine the tax rate you pay.
5. Annual allowance will be cut once you take some money
It is really important for you to be aware that once you have taken money out of your pension savings beyond just the tax-free lump sum, the amount you will be allowed to put into pensions in future will be significantly reduced. If you take only your tax-free cash and nothing else, then your annual allowance stays at £40,000 a year.
However, as soon as you have taken money out of a flexi-access drawdown account, or make just one bank-account style (UFPLS) withdrawal, you will not be allowed to put more than £10,000 a year into a defined contribution pension scheme in future (although those lucky enough to have a final salary-type pension to pay into can still contribute £30,000).
So, if you don't really need to take the funds out and want to have the chance to build up more pension, think carefully before you take more than your tax-free cash.
Overall, the reforms are designed to give you far more freedom than ever before but don't be fooled into doing something you don't need to do, or paying more tax than you need to, or losing out on future pension contributions. There is much to think about in the brave new world of pensions and don't be afraid to take guidance or advice to ensure you make the best decisions.
This article was written for our sister website Money Observer
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
Additional voluntary contributions
If you’re a member of an occupational pension scheme but want to increase your contributions to help boost your income in retirement, this is where AVCs come in. An AVC is a top-up pension that sits alongside your company pension and is administered by your employer. You get tax relief on your contributions and, if you move jobs, you can apply to transfer your AVC plan to your new employer or your AVC your contributions have to stop with your old employer and you will need to start a new AVC plan with your new employer. An AVC linked to a company scheme is subject to the rules of the main pension. (See Free-standing additional voluntary contribution).
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.