More people than ever before are accessing their pensions flexibly, raising questions over whether they are getting a fair deal when it comes to taxation.
New figures released by HMRC this week show that 10 per cent more people took money flexibly from their pensions in the first quarter, and that they took out six per cent more money than the same period last year.
In total, since the freedom to take pension tax flexibly via drawdown or a series of lump sums was introduced, savers have withdrawn £45 billion from their pension pots .
A sting in the tail?
Pension flexibility has many advantages. In many cases, not buying an annuity will leave you with more income in the long run, while if you don’t need the money from your pension immediately, you can leave it invested to let it grow.
Used wisely, these freedoms can be very tax efficient, with untouched pensions passed on to the next generation free of inheritance tax, and the ability to stagger payments from your pension pot to ensure you are not paying high marginal tax rates.
The flipside is that, if you do not take advice over how you withdraw your pension, you may end up paying a high price, in the form of extra payments to HMRC.
Pensions and taxes
When you withdraw money from your pension, a quarter of it is tax free, and can be taken in one lump sum or several tranches. The rest, though, is taxed at your highest marginal rate, meaning that those who access pension money while they still have other sources of income may pay more tax than they need.
By withdrawing even a penny from your pension you also trigger the Money Purchase Annual Allowance (MPAA) which means you can only put £4,000 a year into your pension and claim tax relief, instead of the £40,000 that most people who have not touched their pensions can receive. If you are planning to continue to work in later life and top up your pension, this can drastically affect your plans.
You may also be overtaxed if you take a single withdrawal from your pension, as HMRC will apply an emergency tax code to the withdrawal, which may only be corrected if you fill in the correct tax form. The HMRC processed 38,000 of these forms last year, but given that 600,000 people accessed their pensions for the first time in the same period, many more people are likely to have overpaid and not reclaimed.
Avoiding the tax traps
A careful and holistic retirement spending strategy will help to ensure that you do not fall foul of these tax pitfalls when withdrawing your pension. You will need to be clear about what tax rate you will pay on your pension withdrawal and whether you can mitigate higher rates by spending other parts of your retirement savings first, for example money in an ISA.
It is also sensible to be aware of how you might use your pension to pass down money to the next generation if it is untouched. A financial adviser may talk to you about taking your tax-free lump sum in stages, or even leaving your pension invested for longer, in order to make the process more tax efficient.
Pension freedoms are justly popular, and have made a huge difference in how we can save for retirement, but in order to make the most of them it is important to understand how taxation works. Taking expert advice will ensure you end up with the best retirement income possible.