Avoid these possible traps at retirement
Pension investors now have far greater flexibility with their pension savings at retirement. More than 625,000 pension investors have taken advantage of the freedoms since launch in April 2015, taking over £10.8bn from their pensions. But are there any pitfalls lurking within pension freedoms?
Here we highlight some of the traps hidden in these freedoms and how you could avoid them.
1. You could turn into a 45% income tax payer overnight
From age 55 (57 from 2028), you'll usually be able to take up to a quarter of your pension as a tax-free lump sum. This tax-free cash is yours to spend or invest as you wish. You can then take as much as you like from the remaining pension, even the whole lot if you wish. However these withdrawals are taxable. It was estimated “the pension freedoms” introduced in April 2015 would net the Treasury an extra £3 billion in tax receipts in the first four years.
The withdrawals you make will be added to the rest of your income in that tax year, and subject to income tax at your highest rate. So, they could push you into a higher tax bracket. At the extreme, you could instantly face being a top-rate tax payer (45%) if you make a withdrawal which, combined with your other income, takes you over £150,000.
Worse still, it's likely this payment will initially be taxed at the emergency rate if this is the first time you are taking a lump sum or income from your pension, which increases the likelihood that you’ll over-pay tax and have to reclaim it from HMRC.
There’s another potential pitfall, too. Your personal allowance (the amount of income you can receive without paying tax - which for most people is £11,500 in tax year 2017/18) narrows once your income exceeds £100,000. It reduces by £1 for every £2 of income over this amount. So, if your taxable income is between £100,000 and £123,000 this tax year, you might effectively be subject to income tax of up to 60%.
Tax rules can change and benefits depend on personal circumstances.
How to avoid the trap
2. You could run out of money and become reliant on the state
This is possibly the most dangerous trap of all, as you may only notice its bite once it's too late to do anything about it.
A pension is designed to provide income in retirement, which could last for 30 years or more. If you blow all your pension savings in the early years, or even unwittingly draw an income which is not sustainable over the long term (for instance if you keep your fund invested and it does not perform as well as you expect, or you take excessive withdrawals), your pension might not last as long as you do.
Few will want to be reliant on the state in their old age. Don't underestimate your life expectancy (82% of the population seriously under-estimate this, according to industry research), nor downplay how much money you are likely to need to last your retirement.
How to avoid the trapCalculate what income could be sustainable using drawdown
3. You may be ready, but your provider might not be
There is no legal obligation for providers to offer the freedoms introduced in April 2015. Some firms offer all the freedoms but others don't.
How to avoid the trap
4. You could restrict future pension contributions, and possibly get a fine from HM Revenue & Customs
Most people will have a standard annual allowance of £40,000 when it comes to how much they can contribute to their pensions, and still receive tax relief. However once you flexibly access pension income, via drawdown or as a lump sum for example, the amount you can contribute to defined contribution (e.g. personal or self invested) pensions is limited by the money purchase annual allowance - MPAA. This is £4,000 for tax year 2017/18. Taking tax-free cash alone will not trigger the MPAA.
Savers are required to notify all the defined contribution pension providers with whom they are building up benefits should they start to take an income and trigger the MPAA.
The rules require the investor to notify all such pension providers, so that provider can apply the lower contribution limit introduced from April 2015. They need to do this within 91 days of receiving a certificate confirming they have taken flexible pension benefits or start to build up benefits in the plan if later.
If they don't meet this deadline the investor could be hit with a fine of up to £300.
How to avoid the trap
5. Avoid rushing into any decision
Don't feel you have to rush into a decision. Take your time. Find out your options and ask for an explanation of how things work in plain English. Some of the options are extremely flexible, but due to the risks involved you could make a significant loss, for example if investments were to perform poorly. At the other extreme, some options can't be changed once they’ve been set up, so you could be locked in for life. Check the small print and shop around.