Two common pitfalls of taking money from your pension fund

Published by Ray Black on 29 March 2019.
Last updated on 29 March 2019

Expect some serious watering down of the state pension


Pension freedoms now enable you to access the money you’ve saved in a pension from age 55 and you don’t have to use the money to buy an annuity. Instead, you can transfer it into a flexi-drawdown pension arrangement and access the money any time you like once you reach your 55th birthday.

It can be tempting to draw some out early to pay for home improvements, a holiday, a new car or even just to move some into an Isa or other investment, but beware – just because you can do something, it doesn’t mean that you should.

Pitfall no. 1 – making your income and inheritance tax position worse

You’re 55 or over, still working but haven’t reached state pension age. You’ve decided to take out some of the cash in your pension fund to have in your bank account or invest in another savings plan. 

Why this might be the wrong decision

While your money is held in your pension scheme, any growth in the fund value is tax-free. Once the money is withdrawn, unless you invest it in another tax-free vehicle, like an Isa, any future growth could be taxed.

Money invested in a pension isn’t added to the value of your estate on death. If you take money out of your pension fund, even to put it into an Isa, it will be included in your estate for inheritance tax (IHT) purposes [except when it passes to a civil partner or spouse].

How to avoid making these mistakes

If you are moving money out of your pension fund to put it into an Isa or savings account, think twice. Today’s pension plans are more tax-efficient, accessible and flexible than you might think. Because a pension has superior tax breaks, it tops the list of places most people should have the bulk of their lifetime savings. They are versatile savings tools for both your retirement and IHT planning and, used properly, can provide many families with financial security through more than one generation.

Pitfall no. 2 – paying too much tax on lump sum withdrawals

Again, you’re 55 or over, still working but not yet reached state pension age. You’ve decided you’d like some extra cash to spend on a holiday and a new kitchen. 

Why this might be the wrong decision

If you are withdrawing lump sums out of your pension to supplement your income while you are still working, any amount over and above your tax-free cash entitlement – 25% for most people – is added to your income in the tax year it was received. This could increase your tax bill considerably.

When you draw a lump sum out of your pension, unless your pension provider holds an up-to-date tax code for you, most lump sum payments will be subject to income tax at an emergency rate. For many, this is likely to result in an overpayment of tax when making their first withdrawal.

How to avoid making this mistake

Consider taking a regular income instead of a one-off lump sum. Some pension providers will allow you to take a regular income that is made up of 25% tax-free cash and 75% taxable income. For example, you could take £200 a month made up of £50 tax-free cash and £150 gross. Only the £150 is added to any other taxable income.

Taking an income in this way means your pension provider will liaise with HMRC, which will, in turn, send it your personal tax code so that it can work out the correct amount of tax to deduct.

Ray Black is a chartered financial planner and founder of Money-Minder.com

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Pension withdrawal

I am approaching 70 years of age. I intend to cash in two pensions I have with Sun Life. About £21K. My intention is to open a cash ISA with Virgin. Taking only the tax free amount . Is this allowed.
Regards, Colin.