The changes to pension rules announced in the 2014 Budget were supposed to provide greater flexibility by allowing savers to access their nest egg prior to reaching retirement age. However, as Dorset-based independent financial advisor and pensions specialist Chris Ryan from Apex CB Financial Planning explains, unlocking your pension early could come at a cost.
“We have been approached by clients looking for ways to unlock their pensions, having read in the press about the new pension framework, introduced in the 2014 Budget” says Chris.
“The focus on the government white paper was to make flexible access to pensions available to more investors. Under the old system in place before the Budget, only those with a very large pension pot typically worth over £100,000 or those with total pension wealth below £18,000 could access their pension savings flexibly, with many forced to buy a fixed and inflexible annuity to provide retirement income.
People are now being “trusted with their own finances” to be able to access their pensions from age 55 in a flexible manner, irrespective of the size of the pension pot. In 2015, Hymans Robertson, a pensions consultancy, predicted that these new rules would mean that more than £6 billion would be withdrawn from pensions in 2015.
But should you do this? Is it a good idea to take your entire pension out and use these savings to buy a classic car, or invest in property? We have found a number of reasons why investors should think twice before doing so.”
“The first problem is tax. Although the first 25% of the pension taken (the Pension Commencement Lump Sum or PCLS) is tax free, the balance is subject to income tax. However the rate of tax collected on the balance will depend on when in the tax year the taxable lump sum is taken.
The income is initially set up with an ‘Emergency tax code’, commonly ‘Emergency Month1’. An ‘Emergency Month 1’ tax code essentially means any income is tested against 1/12th of the personal allowance, 1/12th of the Basic Rate tax band and so on. This will continue to apply until the pension provider receives a tax code from HMRC.
The table below shows the taxation of income payments where an ‘Emergency Month 1’ tax code applies whilst awaiting the tax code from HMRC.
|Tax Band||Tax Rate||Annual Tax band amounts||Month 1 (annual/12) position on payments|
This means that a pensioner with a £9,000 State Pension as their only income and who takes a £25,000 taxable lump sum from their pension could pay £9,698.10 income tax, i.e. 38.8%. The situation becomes much more complex where there are other sources of income, so it is therefore vital to seek advice first before deciding to cash in your pension pot. There are ways around this which rely on detailed knowledge of the tax system.
The Telegraph reported that the Treasury has received around £1.2bn in extra income tax as a result of these new pension freedoms, so careful thought is required if you want to avoid swelling the Treasury’s coffers even more.”
“It is worth considering whether alternative investments are really a better alternative to the pension. The problem that we often find is that few of our clients really understand what their pension could do for them, and how the investment inside it works” says Chris.
“The popular misconception is that the insurance company puts it into a financial black hole returning barely more than the value of premiums paid in. However many pensions now offer access to over 5,000 managed investment funds like those found in ISAs, low cost index-trackers, access to shares on all the major world markets, and commercial property such as shops and offices. All of which is held in a pension wrapper that deducts very little tax on income earned and suffers no tax at all on any profits made.”
“Many of these clients who come to us from around Dorset and Hampshire have failed to engage with a financial adviser for many years and have pensions that are in a fairly poor state, which mirrors their confidence in the financial services profession. If you failed to look after your house or car in the same way, ask yourself “what condition would it be in?”
As an example, Mr B from Poole came to see us recently with around £170,000 spread across 5 pensions, some of which dated back to the 1980’s. He hadn’t had them reviewed for many years and found that the pension company hadn’t paid any bonuses since 2004. He was totally confused about his options as he approached his 65th birthday.
After analysing the pensions we recommended an amalgamation into a single plan that offers the new more flexible options, allowing him take what he needs as he winds up his business without committing to a fixed monthly sum, and with the option to take the tax-free element in stages to supplement his business income without triggering further tax.
As Mr B was concerned about market risk to his pension we set up an investment that offered protection from stockmarket volatility and would allow him to draw down more than he could from a fixed annuity, reducing the risk of depleting the fund.
The great news about recent pension changes is that your family can now inherit what’s left of your pension fund without hitting the 55% tax charges introduced by Gordon Brown’s government, with no Inheritance Tax either. This gives you the ability to pass on a tax free lump sum if you die before drawing the pension, or a fund that your beneficiaries can draw from and just pay the same rate of tax as if they had earned the money drawn from the pension. Pensions have once again become a tax shelter for family wealth that can benefit not only your spouse, but your children and grandchildren too.
So, the lesson is learn to love your pension and watch it grow and thrive, and neglect it at your peril.