When the Government announced back in 2014 that people would be able to take their pensions flexibly, experts were worried that people would blow their cash on classic cars and fast living.
Last week it became apparent that many are using the funds for something more serious: getting them through the Covid-19 pandemic.
Figures from HMRC1 on pension withdrawals show that 10 per cent more people withdrew cash from their pensions in the last three months of 2020 than the same time in 2019.
But while more people are withdrawing from their pensions than before, each person is taking slightly less, on average, than at the end of 2019.
There has been plenty of speculation about what people are using the withdrawal money for – to compensate for Covid losses or to support family members who are struggling are two of the suggestions - but the most important message to give to those withdrawing from pensions is that they must ensure they are doing so with an eye to the long term, and in the most tax-efficient manner they can. Here’s why.
Why withdrawals matter
Many of us spend our working lifetime building up a pot of retirement savings. When we give up work and start to spend them, we enter what is rather grandly called the ‘decumulation phase’ - as opposed to the ‘accumulation phase’ we were in before.
Decumulation might sound more fun - spending instead of saving - but in fact it is the beginning of a careful balancing act which, if all goes right, can leave you with enough to live on comfortably while handing the remainder to your relatives, rather than the taxman. The key is all in how, and when, you withdraw the money.
You can withdraw your entire pension, if you like, at the age of 55, and either put it in a bank account to spend when you want it or spend it all as soon as you get it.
Doing this could be a huge mistake, however, which is why even those with a small pension pot and simple affairs are offered a free financial consultation with PensionWise2 when they approach retirement. Many will require more help than the government service can give, particularly if they’ve been saving for retirement for some time or have dependents that they wish to help.
Taking decumulation seriously
There are several reasons for this. Firstly, your pension pot needs to last you for the rest of your life. Since none of us knows how long that is going to be, complex calculations must be made, bearing in mind our retirement plans, possible care needs and current situation. Retirement spending tends to change over time, while inflation also needs to be factored in to ensure that the money lasts as long as you do.
In addition to this, the effect of taxation on your decumulation strategy can be huge, but is easily minimised. That is because, although 25 per cent of what you save into your pension can be withdrawn at any time tax-free, the rest must be taxed at your ‘marginal rate’.
Your marginal rate is simply the highest tax rate you pay at the time, so if you are earning £50,000 and withdraw a big taxable sum from your pension in the same year, the lump sum will tip you into the higher rate tax bracket and you’ll pay tax at 40 per cent on it. Take the same money out in a different year, when you are earning less, and you may pay a lower rate of tax, or even none at all if it is within your annual allowance. Structuring your pension withdrawals with this in mind will make your money go further.
While your pension remains unspent, it can be invested, giving it further potential to grow. The risk/reward ratio for this needs to be carefully managed so that you can have access to money that you need but also take on enough risk to grow your pot. A financial adviser will help to change the risk profile over time, using a process known as lifestyling.
Finally, the rules around pensions mean that if they are unspent, they can be passed onto the next generation in a very tax efficient way, plus they do not count as part of your estate for inheritance tax reasons. So it may make sense to spend other savings first if you are hoping to leave a legacy for the children.
Whatever reasons you have for taking money out of your pension, you should always think through the implications first. An adviser could help you to understand whether you are making the best decision at this time and in these circumstances, and help you to see a bigger picture, helping you towards a more prosperous retirement.