Retirement savers who want to take money from their pension under the government’s new flexi-banking rules could face a nasty tax shock.
The main problem to consider is tax treatment of your tax-free 25% lump sum.
If you want to draw that lump-sum without paying tax, then you need to do so before April 5 next year while current tax rules apply.
From April 6 onwards that 25% tax-free lump sum disappears, although you still pay no income tax on 25% of your retirement savings held in a pension.
The rules sound confusing, but that pension freedom is a little more restricted than Chancellor George Osborne would have retirement savers believe.
The issue is retirement savers with more than one pension.
They are entitled to take a 25% tax-free lump sum from each, but no system is in place to tot up how much each saver withdraws from different providers so HM Revenue & Customs (HMRC) can track when the 25% tax-free limit is reached.
Avoiding the tax trap
Instead, The Treasury and HMRC have devised a tax process that allows retirement savers to take 25% of each withdrawal tax-free. The remainder of the withdrawal is taxed at the saver’s marginal rate, which is the highest rate they pay income tax in the tax year when the withdrawal is made.
The risk for pension savers is they can push themselves into the higher rate tax bracket by drawing a large lump sum.
Different options to save tax depend on income and age.
- For under 65s who are working, calculate how any pension withdrawal will affect your overall income for the year. If you are already paying higher rate tax, 75% of any pension cash you take will be taxed at 40%.
- For those about to qualify for state pension payments, consider deferring the state pension to reduce your income to zero and draw on your personal pensions. That way, you will earn above market rate interest on your state pension and pay lower rate tax on your pension drawings, providing you have no other income
The drawdown tax rules will also apply to offshore pensions like Qualifying Recognised Overseas Pension Scheme (QROPS).
Charges and fines
However, some QROPS may pay a 30% tax-free sum, rather than 25%, depending on the financial jurisdiction and rules of the scheme.
Other financial issues to consider before drawing the cash from a pension include charges imposed by pension providers to process the withdrawal and warnings from HMRC that pension savers have 30 days to inform all their pension providers of any cash drawdown.
If they do not pass the word on, they will face a £300 fine.