12 CRUCIAL CONSIDERATIONS FOR YOUR PENSION WITHDRAWALS
Before you take any pension withdrawals, read this article. You have been saving for years, and it is your money, so why shouldn’t you withdraw money from your pension? We examine 12 crucial considerations to think about before you take pension withdrawals.
A recent report by Citizens Advice estimates that 29% of people who access their pensions under new flexible pension rules do so just to put the money into a bank account. This article explains why this is probably a bad idea.
- Background to flexible pensions
- Citizens’ Advice report reveals most popular reasons for pension withdrawals
- 12 crucial considerations before you take a pension withdrawal
- Pension withdrawals – a general rule
- What to do next?
Flexible pensions – background
The rules on flexible pensions now give you much more control over how you access your money. You can now access all of your pension fund at any stage from age 55. Part of your pension fund is tax-free – usually 25% if it is a personal pension. The remainder is taxable as income in the year you take the fund. You can choose to access part or all of your pension fund at any stage, so you can stagger payments to minimise tax.
The newspaper coverage on flexible pensions has been widespread, leading many people to believe that pensions have become as simple as bank accounts. Unfortunately, this is not the case. Taking your money out of your pension can have many unexpected outcomes. These include paying more tax, affecting your future ability to save into schemes, and reducing your future income prospects.
The Citizens Advice report
The report from Citizens Advice makes interesting reading.
The research indicates that flexible pensions are popular as the reforms have meant increased control over your savings and income. The second most popular reason was having the ability to enjoy the funds earlier. Interestingly, the third most popular reason was cited as saving tax, which is an issue we deal with below.
The most popular reason for pension withdrawals cited in the Citizens Advice report was to put money in to a bank account. This seems to reflect back on the desire for control over your money – it’s your money after all, and why shouldn’t you have access to it? However, will often be a bad idea:
Pension withdrawals – 12 crucial considerations
- How long will the pension money last?
Now that you have access to your pensions it is tempting to access them earlier than you might have done. Think about how long this money needs to last you. How long will you live? How much income will you give up in the future if you take a lump sum earlier rather than later? 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 a pension withdrawal now.
- Your health
Your health has a major bearing on whether you should take a pension withdrawal. If you are in poor health you may be able to get a better guaranteed annuity rate due to decreased life expectancy. You should also think about whether you plan on passing on your pension fund to your family after your death.
- Your personal circumstances
You need to assess a range of other aspects of your personal and financial life before you take a pension withdrawal. Taking money from your pension is an irreversible decision. Think about your plans for work and future income, your spouse and other dependants, plus other considerations such as debts.
- Income tax implications of pension withdrawals
If you withdraw money from a pension, you get to take 25% tax-free; the rest of your fund will be subject to income tax.Taking the tax-free cash element could save you tax if you use the money to replace other income for that tax year. You could get some tax-free ‘income’ from your pension, but remember that income from other sources would still be subject to tax. This would be a sensible use of your pension money, provided you spend the money. Just be aware that once your tax-free cash element is used up, any future withdrawals will be fully taxable.If you take withdrawals from the taxable element, you could end up paying tax at 20%, 40% or 45% depending on how much you withdraw. If you plan on simply taking your pension money and leaving it in a bank account, you could find that you pay significant tax on this withdrawal. At the very least you should not take all your pension fund in one withdrawal – this would be the least tax-efficient way to take your money.If you are not planning to spend the withdrawal from your pension then you would have been better off leaving it in your pension. Pension savings grow tax-free, but you could end up paying tax on the withdrawal when it is taken from your pension, and further tax on the savings growth in the future. If you do not plan on spending your pension income now, leave it in your pension.
- Inheritance tax implications of pension withdrawalsMost pension funds can be passed to anyone free of tax if you die before age 75, and are taxed as income if you die after age 75. This is a major way to save inheritance tax. Your pension plans can be passed to future generations without affecting your nil rate band for inheritance tax. If you take your pension income and then do not spend it, this money will become part of your taxable estate for inheritance tax. If you do not need the money, leave it in your pension.
- Changes to your ability to save into pensions after a withdrawal
Once you take an income from your pension, you restrict the ability to make future contributions into your pension. In many cases. this will reduce your pension annual allowance for contributions to £10,000 (£4,000 from April 2017). Savings above this figure could attract additional tax. You should only reduce your ability to make future savings if you are sure that you will not want to make further contributions.
- Bank accounts mean low returns
If you take a withdrawal from your pension, what will you do with it? If your plan is to simply place it in a bank account, how much interest can you expect? Most bank accounts pay a paltry rate of interest, and this could even be behind inflation. Your bank savings will attract tax, which will further reduce the returns. At least if your pension money is invested you have a better chance of growing the money in the medium to long term. You can even approximate bank account risk within your pension if you want.
- Other sources of cash
Don’t forget that you may have other sources of cash other than your pension. It may be appropriate to consider using other assets before your pension. For example, withdrawals from ISAs are tax-free, while pension withdrawals are likely to attract income tax. Other investments may attract capital gains tax if you sell them, so be careful.
- Investment risks
Taking money from your pension can have unwanted effects if you take withdrawals at the wrong time. For example, if you take pension withdrawals when your funds have fallen in value, this can severely reduce the length of time your funds may last. In addition, if you continue to take withdrawals after a fall in value to your pension fund, this can also have an effect. You should consider the timing of your pension withdrawals very carefully.
- Pension guarantees
Some older pension plans offer guarantees, either to the fund or to the future income you will get. If you take a pension withdrawal early you may lose these guarantees. In some cases your guarantees could effectively double the value of your underlying pension fund. You may have good reasons for giving up pension guarantees, but taking this action should only be done after careful consideration.
- Other types of pension
Don’t forget that you do have other options for taking pension withdrawals. For example, you can also take a secure income from a traditional pension annuity. These still offer good value and security for many people, especially if you plan on living for a long time.
- The pension lifetime allowance
If you take a taxable pension withdrawal this is likely to be assessed against your lifetime allowance. This is £1.055 million for most people, so you may not need to worry about it. However, if you have a large pension fund you should only take pension withdrawals after first calculating how your lifetime allowance will be affected. Failure to take this step could mean unexpected additional tax, now or at age 75.
Pension withdrawals – a general rule
My general philosophy on pension withdrawals is that you should only take the money out of a tax-free environment if you plan to spend it. If you have no plans to spend the money, then leave it where it is. The pension funds will grow tax-free, and you can pass it on to your family if you die without paying inheritance tax. Always remember that you can always access your pension money in the future if you do decide you need some income.
Considering pension withdrawals – we can help
Contact us if you want to examine the effects of taking pension withdrawals. We can examine all of the issues above, and show you the full effect of your pension withdrawals on your future income and security.
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About Dan Woodruff
Certified Financial Planner & Chartered Wealth Manager at Woodruff Financial Planning
Financial Planning helps you to navigate and anticipate significant life changes. I want to help you to ensure your money is managed wisely to give you the financial security that will fund the future and lifestyle that is important to you.