Pension freedoms give retirement savers choices about how they can spend their money once they hit the age of 55 years old.
Introduced in April 2015 by then Chancellor George Osborne, the idea was to strip away the stifling rules that left some people struggling to make ends meet even though they might have tens of thousands of pounds tied up in a pension.
In the intervening period, the Financial Conduct Authority has revealed that accessing a pension early – before retirement age – has become the new normal.
Most retirement savers are taking lump sums instead of regular incomes and 53% of pensions accessed under the freedom rules had all their cash taken.
The study also revealed that too many retirement savers were not shopping around for the best pension deals and were not taking advice before withdrawing their money.
What is Pension Freedoms
Pension freedoms give savers six options for taking their retirement cash:
- Leave the full fund invested in a pension
- Draw all the money in one go
- Draw money in regular payments
- Draw money when a top-up is needed
- Buy an annuity that offers a guaranteed income for life
- A pick-and-mix of all the options
Deciding which way to take pension cash will vary for each retirement saver as they will have different amounts saved and their own opinions about when and how to spend their cash.
Here, the tax-free lump sum and each option is explained, along with the tax implications:
The pension tax-free lump sum
Retirement savers generally choose to take 25% of their pension money tax-free and then move the remaining cash into one or more other funds that let them draw the rest of the money as it suits them.
QROPS offshore pensions may allow savers to take a larger tax-free lump sum – up to 30% of the fund value.
Simply drawing the tax-free money is not always the best tax option.
If you have no other income other than pension cash, you still have a £11,500 personal income tax allowance each year. Although the state pension will take a chunk of this, most people can still draw up to £3,500 a year from their other pensions without paying tax.
The tax dilemma for retirement savers
HM Revenue & Customs tax treats pension withdrawals as payroll. The problem with this is if you take £15,000 from a pension, tax rules treat this as an annual payment of £120,000 and will tax all the money above the tax-free lump sum.
The personal allowance is allocated as 1/12 of £11,500 and higher rate taxes at 40% and 45% are applied as well even if no other income is taken from the pension during the year.
This means some people massively overpay tax. The overpayment can be reclaimed but the process takes a month or so and sometimes retirement savers must take more money than they need to account for tax.
The money cannot go back into the pension easily. A rule called the money purchase annual allowance (MPAA) applies as soon as money is taken from a pension.
This rule limits the amount of money someone can pay into a pension to £4,000 a year once the fund has been accessed.
Leave the full fund invested in a pension
If you don’t need the money because you have other income, perhaps from a salary because you are still working or money from more than one pension, then leaving the cash invested is a good choice.
Leaving the fund untouched means paying no tax on withdrawals and ring-fences the money outside your estate for inheritance tax, as pension funds are exempt from IHT should you die.
Meanwhile, the fund continues to grow under investment.
You will need to decide before your 75thbirthday about what to do with the money as the IHT treatment of the money changes on that date.
Draw all the money in one go
A popular option with retirement savers who have pensions worth less than £30,000.
The tax overpayment dilemma will probably apply to pension funds of £10,000 or more.
Other issues to bear in mind if taking the pension as one lump sum include not having a fund to pay an income and flouting ‘deprivation of capital’ rules if you apply to the local council for help with rent, council tax or long-term care costs.
These rules block the payment of benefits if someone is considered to have deliberately spent their savings so they can claim benefits.
Draw money as regular payments
This option is using your pension pot to provide a flexible retirement income, typically paying a fixed amount each month. This comes with the ability to stop or vary payments whenever you wish.
The payment generally comes with the first 25% tax-free and the rest as taxable income, providing you have not already spent the tax-free lump sum.
The facility does not guarantee a retirement income and the payments are not linked to increases in inflation.
Draw money when a top-up is needed
Taking money as and when needed, much like visiting a cash point, leaves the rest of the pension untouched and allows continuing tax-free growth.
With this option, retirement savers must keep an eye on the yearly tax to make sure they remain in the tax-free or basic rate tax brackets.
Buy an annuity that offers a guaranteed income for life
Before pension freedoms started in April 2015, this was the default option for pension planning in retirement.
Savers took their 25% lump sum on retirement and then bought an annuity with the rest of their fund.
Now, buying an annuity is much less common because low returns have diminished their value.
Annuities come with a guaranteed income for life and with different options for enhanced and joint contracts.
A pick-and-mix of all the options
Pension freedom rules do not insist that you must choose one drawdown option and then stick with it – except in the case of annuities.
You can mix and match the options as you wish, taking tax-free cash, a regular income and topping that up with occasional lump sums.
Retirement savers can find help about how to work out their financial choices on the independent and free to use Pension Wise web site