You’ve spent decades toiling away, conscientiously paying into your pension. If you are fortunate enough not to be reliant on your pension to fund your retirement, then you might want to leave it untouched as something that can be passed onto your heirs without being impacted by IHT. Otherwise, at some point you are going to want to start withdrawing money from it. But is that necessarily your best course of action?
Our Director of Private Clients Nick Rolf is a mine of information when it comes to everything from estate and trust planning… to retirement and pensions. This week, he considers various factors you should think about before deciding to crack open your pension pot. And when you do, how best to draw on those assets tax-efficiently.
The first thing to bear in mind is that we are all living longer, and so whatever age thresholds apply today are likely to be extended over the next few decades. But as things currently stand, once you hit 55, you can withdraw 25% of your lifetime allowance, tax-free. This will rise to 57 in April 2028 (unless you have a lower protected pension age). If you want to take more out, whatever you withdraw over and above that 25% limit will be subject to income tax at your marginal rate.
The second important point to remember is that once you've accessed your pension pot, it essentially becomes "crystallised", meaning you've committed to a specific method of accessing your funds. Consequently, you may no longer be allowed to withdraw any additional tax-free cash from that crystallised portion of your pension, even if its value increases.
Is breaking into your pension your only option for funding your retirement?
Remember that taking money out of your pension comes with consequences, so ask yourself a few questions before doing anything. Do you have a good reason to touch your pension? It’s worth taking stock of your finances and looking at your other assets and potential sources of income. You might, for example, be better off selling a buy-to-let property or accessing an ISA first.
What are you going to do with the money that you draw from your pension?
Money that is locked away inside a pension pot is tax advantaged. You might decide that you want to withdraw your tax-free 25% lump sum and place it in a savings or investment account. The problem is that anything it earns is immediately subject to tax. Needless to say, you could find a new home for your lump-sum in an ISA. But remember that the amount you are able to pay in per annum is currently capped at £20,000.
Furthermore, the bank deposit will be included in your estate for inheritance tax purposes. When that money is inside a pension, it is exempt from inheritance tax.
So make sure you have a good reason to take out any tax-free cash. Of course, you may need that money to pay off some debt. Or you might want to help your children buy a house. But it very rarely makes sense to withdraw it simply to sit on it.
Needless to say, you are under no obligation to take out all of your tax-free cash. You can take out whatever you need and then leave the rest inside your tax-advantaged pot.
What is the best way to draw from your pension?
There are a number of ways to take your pension. One is to leave some of the money invested (so it can grow) and take part of it as income. This is called income drawdown but that is not the only option open to you. You could purchase an annuity, which would effectively give you a guaranteed income for life – a set amount every month until you die. If you wanted, you could take your entire pension in cash when you hit 55. The first 25% – up to the lifetime allowance – would be tax-free, and everything else would be taxed at your highest marginal rate. Needless to say, you are under no obligation to take your pension if you do not yet need the money – you might prefer to defer it until later, giving you time to think about how best to use it to provide for your future.
You could mix a number of different options – it will depend on your tax situation. If you draw out more than the tax-free cash element, then you are going to pay income tax on what you take out. You need to consider whether or not doing so will run the risk of taking you from the basic-rate band to a higher-rate band.
Remember that if you take more than the tax-free cash from your pension pot (or anything that is taxable), then you trigger the Money Purchase Annual Allowance, which means that you are then capped on how much you can put into your pension in the future (£10,000 per annum). So if you are drawing on your pension, but you plan to make large contributions in the future, you might be limited in terms of what you can put in.
Another consideration is that the tax-free element that you can take from your pension is a percentage of the value of the pension. So as the pension grows over time, so does the amount of tax-free cash that you can take from it. It is capped at 25% of the lifetime allowance. So if you have a pension pot worth half a million pounds and you want to take 25% out of it in the form of tax-free cash, that equates to £125,000. But if you left it there and the pot doubled to £1 million over a 10-year period, then you could potentially take out twice as much tax-free cash.
When is a good time to withdraw the money?
Generally, drawing money from your pension means selling off investments to realise the cash. But in a world characterised by two major wars and very sluggish global growth, the markets are currently extremely volatile. As a result, many people's pension pots will have taken a hit. A general rule of thumb is that if you do not need the money straight away and have some flexibility about withdrawing your tax-free lump sum, then try to avoid doing so in the immediate wake of a heavy loss.
Do not attach too much importance to small market movements. Just bear in mind that if you were to withdraw your money right now with any losses in your portfolio, you would lock in those losses before your pension had had a chance to recover. You might be better advised to leverage other assets or run down any cash reserves that you have outside of your pension, leaving those investments to recover somewhat.
Whatever you decide will depend on your financial circumstances. Investment Quorum is highly experienced in advising our clients on such matters and fashioning a roadmap for them – just as we do for them while they are still working. Feel free to have a conversation with us about your future plans. We can help you answer the numerous questions you will doubtless have, and help you decide whether you want to set up a guaranteed income via an annuity or use your money to provide a long-term flexible income.
Contact us to ensure your plans are on track. We can tailor your investment strategy with us to meet your retirement needs.
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