With savers facing a volatile market in the face of Covid-19 uncertainty and HM Revenue and Customs (HMRC) reporting a 21% drop in pension withdrawal levels during lockdown, it is being recommended that people consider a number of key points before accessing their pensions.
Data published by HMRC on 31st July showed that £2.3 billion was withdrawn from pensions flexibly in the second quarter of 2020 – down from £2.8 billion in the same period last year. The average amount withdrawn was £6,700 in the quarter, an 18% decrease from £8,200 in Q2 2019.
While average pension withdrawals have been falling steadily, there is normally a peak in quarter two as it coincides with the beginning of the new tax year. However, according to HMRC, the impact of Covid-19 has caused a reversal of this trend.
Pension freedoms began in 2015 and the rules allow you to take out as much as you want from your pension from the age of 55. Normally, you can take 25% tax-free from your pension, with the remaining 75% subject to your marginal rate of income tax. While these flexibilities may seem tempting, you should carefully consider whether taking money from your pension is the best course of action.
Pension withdrawals – key points to consider
How much do you need?
The main purpose of a pension is to provide you with an income throughout retirement, therefore, taking a lump sum before you retire could have a big impact on your funds in retirement.
If there is no other alternative to taking money from your pension, it is important to take only what you need to allow the rest of the money to benefit from future market rises.
The majority of people take the maximum tax-free lump sum of 25% when they first access their pension. If you do this, any further money taken out would be liable to tax at your marginal rate of income tax.
Instead of taking all the tax-free cash in one go, it is possible to take a small tax-free lump sum at the outset and retain the ability to take further tax-free lump sums later in retirement.
How much tax will you pay?
As mentioned previously, once you have taken the 25% tax-free cash from your pension, any further withdrawal is liable to income tax. If you take a large taxable withdrawal from your pension, it could push you into a higher tax bracket, meaning you pay more tax.
The first time you take a taxable withdrawal from your pension, the pension provider will deduct income tax. HMRC will assume that the amount withdrawn will be the same every month, even if you are only taking a one-off withdrawal. More often than not, this results in paying more tax than you should, although you can claim the extra tax back from HMRC.
Do you have any other savings?
As accessing your pension is a major step and can have unintended implications, it is important to explore other options first. For example, do you have any other cash savings or investments that you could use? Are you eligible for any Government grants or state benefits? You may have cash savings but if it is your emergency fund, it might not be the best place to take it from.
With a defined contribution pension, it is likely that a significant proportion of it will be invested in the stock market, which has taken a hit in recent months .Therefore, if you take a withdrawal from your pensions now, that money won’t have the opportunity to regain its value in the future.
How long will your pension need to last?
Your pension is there to support you throughout retirement. If pension withdrawals are required, it is important to consider exactly how much you need and whether it will leave you with enough money to last the duration of your retirement. It is worth noting that a 67-year-old male and female have an average life expectancy of a further 20 and 22 years respectively.
Think about how much income you will get in retirement from all sources, and this will help to guide you on whether it is sensible to take pension withdrawals now. Taking a lump sum early on in retirement or while you are still working could have a detrimental impact on your pension pot for the rest of your retirement. However, it is not an easy task working out how long your retirement savings will need to last so regular reviews are essential.
Will you continue to contribute to your pension in the future?
If you take more than the 25% tax-free cash from your pension, there is an unintended consequence in that the Money Purchase Annual Allowance (MPAA) is triggered. This restricts the amount that can be paid into your defined contribution pension to £4,000 a year, which also includes both your contribution and your employer’s contribution. If you exceed this amount, a tax charge will be incurred.
Do you want to pass funds down to beneficiaries on your death?
As part of the pension freedoms introduced in 2015, the way pensions are taxed on death changed. If death was to occur before the age of 75, the pension can normally be passed free of tax to your beneficiaries. If death occurs on or after your 75th birthday, the fund is taxed at the recipient’s marginal rate of income tax.
It is important to check the position of your pension on death with your pension provider as not all pensions benefit from these updated flexibilities.
Using other assets and keeping money in your pension to pass onto beneficiaries is likely to be more tax efficient than passing money on through your estate, if you would be liable to inheritance tax at 40% on death.
While it is clear that pension freedoms legislation has made pensions more accessible than the days of having to buy an annuity, it does come with risks. It is, therefore, important to seek advice on what is best for your personal circumstances.
How Nelsons can help
For further information on the subjects discussed in this article, please contact a member of the Investment Management team in Derby, Leicester, or Nottingham on 0800 0241 976 or via our online form.