Think of taking money out of your pension? Watch out for possible traps, including unexpected tax charges and limiting future pension contributions.
From April 2015, what you can do with your pension pot changed significantly. If you have so-called ‘money purchase’ or ‘defined contribution’ pensions (where you have a pot of pension savings, rather than a promise of a certain level of income), you can use those savings flexibly, normally from age 55.
This means that you may choose to take out lump sums rather than a steady stream of income. Our guidance on pension flexibility explains further.
There are some key things you need to understand before you make pension choices. These are all explained in further detail in the above guidance, but below we provide a checklist of things to watch out for.
1) Watch out for scams
The minimum age that most people can take money out of pension is 55, as noted above.
Be extremely wary of any companies or schemes that appear to offer you earlier access to your pension. Not only could you lose your savings, but you could also be left with a tax charge of up to 55% of the amount withdrawn.
Further guidance is available from the Financial Conduct Authority.
2) Don’t rush
Consider everything – your circumstances (personal and financial), investment choices, future plans and, importantly, tax consequences.
Since the introduction of pension flexibility, we have seen a number of people taking money out of their pensions and simply putting the cash in the bank or into an Individual Savings Account. This could cause unnecessary tax bills and might not be the best investment decision – think carefully and take advice if you can (see below).
3) Know the tax consequences of your decision
You are allowed to take some money (usually 25%) out of your pension tax free, but the rest (usually 75%) is taxable as income. Taxable amounts will be added to your other income, probably giving you an extra tax bill.
We have seen people cause themselves some very large tax bills since pension flexibility began. Tax charges can include a high-income child benefit charge when a pension withdrawal pushes income over £50,000, and this also means you must notify HMRC that you need to fill in a Self Assessment tax return.
In one such case, the pension withdrawal had already been spent on home repairs before the taxpayer became aware of this high income child benefit charge, which left him with a tax debt of over £2,500.
Therefore, plan ahead: you might pay less tax on money from pensions if you take it in stages, spread it out over a number of tax years, or wait until after you have stopped work. And make sure you know the tax consequences before withdrawing the money and certainly before spending the money!
4) Understand the tax ‘paper trail’
Money from pensions will be taxed under the Pay As You Earn (PAYE) system, however you might not pay the right tax at the right time. You might need to claim a tax refund or pay some more tax later, and HMRC might send you a tax calculation or Self Assessment tax return.
5) Watch out for tax credits consequences
If you claim tax credits, taking money out of a pension could cost you dearly. This is because taxable income from pensions is also income for the purposes of tax credits.
You could end up with a tax credits ‘overpayment’ – this means that you may have been paid too much and have to pay it back. It could also mean you end up with less tax credits in the following year as well.
You do not actually have to tell the Tax Credit Office about changes to your income until you renew your claim at the end of the tax year, but you might wish to tell them sooner about money taken from a pension in order to reduce the amount of any overpayment.
One mistake that we have seen tax credits claimants making is reporting the whole of their lump sum as tax credits income. As mentioned above, it is only the taxable part that is income for tax credits; any tax-free lump sum does not have to be included.
6) Check the effect on state benefits (including universal credit)
One-off or irregular sums taken from pensions could be treated as ‘capital’ for the purposes of means-tested state benefits, but regular amounts are likely to be treated as income.
Either capital or income treatment could have an immediate effect on your entitlement to state benefits, depending on your overall circumstances, and ‘local’ benefits like council tax reduction could also be affected.
As in point 3 above, child benefit can also effectively be reduced or lost where a large pension withdrawal creates a high-income child benefit tax charge.
Check your situation carefully before taking money out of your pension.
7) Think about whether you still want to pay into pensions, and how much
As long as you are under the age of 75, are UK resident and have relevant earnings (or pay in less than £3,600 a year gross), you can still contribute to a pension after taking money purchase pension benefits.
However, tax relief is limited to contributions of £4,000 a year gross where you have taken money purchase pension benefits – this is known as the money purchase annual allowance. Be aware of this if you are likely to want to pay more into your pension in future.
8) Get help
Get government guidance: Use the government’s ‘Pension Wise’ guidance service – either online, or by making a telephone or face-to-face appointment. Note that this will only provide you with guidance, not full advice.
Get tax advice: Get specialist advice on your tax position – see Getting help for more information.