You've spent decades toiling away, conscientiously paying into your pension. At some point, you are going to want to start withdrawing money from it. But open the papers and you will read about energy price increases, inflation and the rising cost of living more generally. Is the idea of a financially comfortable retirement increasingly far-fetched? How much of your savings can you spend annually without running the risk of outliving your money or losing your buying power relative to inflation?
Our chartered financial adviser and 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 ponders some of the things you might like to consider before you decide it’s time to break into that pension.
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 somewhat over the next few decades. But as things currently stand, once you hit 55, you can withdraw 25% of your pension pot, tax-free. 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.
But be careful if you do decide to take more out. There are a few things to consider before doing so. Most importantly, once you have taken income or tax-free cash from your pension pot, that pot essentially becomes “crystallised”: you have committed to a particular retirement income route for your funds. This means you may no longer withdraw any further tax-free cash, which would prevent you from building up any further entitlement to tax-free cash.
There is a perception that money inside a pension is somehow abstract or intangible, and that it only becomes concrete and real once it has been extracted from that pot. That might explain why so many people jump at the chance to access their tax-free cash as soon as they can. The Minimum Pension Age – the earliest you can currently access your pension savings – is 55. But in 2014, the government announced that this will rise to 57 in April 2028 (unless you have a lower protected pension age).
Taking money out, however, comes with consequences. Money that is locked away inside a pension pot enjoys a measure of fiscal protection. 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, and you may be prevented from claiming certain state benefits by having additional assets in a bank account.
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 the whole 25%. You can take out whatever you need and then leave the rest inside your fiscally protected pot.
First and foremost, your pension is designed to provide you with an income once you have stopped working. You might use it to purchase an annuity. Drawdown is a way of having a pension income once you retire, while at the same time allowing your pension fund to keep on growing. Instead of using all the money in your pension fund to buy an annuity, you leave your money invested (needless to say, there is a chance that it might go down in value as well) and take a regular income directly from the fund. An advantage of doing this is that it will continue to benefit from tax efficiencies too.
But taking out 25% from your pot will impact its compounding – you will essentially be compromising your pot's ability to generate future income. And if you withdraw money from the age of 55 (57 from 2028) – when you may still have a good decade or so before you retire – you are preventing that money from growing in value via investment returns.
For example, 25% of £800,000 gives you a tax-free lump sum of £200,000. But if your pension fund has grown to £1 million, your tax-free lump sum is £250,000 – meaning you get an extra £50,000 tax-free.
We can help you get an idea of what the implications of withdrawing tax-free cash might be.
If you have children, the chances are you going to want to leave them money when you die. But if you have accumulated considerable wealth, then it is likely that whatever money you leave them will be subject to inheritance tax. As long as your money is in a pension, it is afforded some protection against IHT. It may even be excluded from your estate for IHT purposes.
So if you are able to meet your financial goals using alternative means, that might justify leaving it alone for the time being. There are a number of ways to avoid paying a hefty inheritance tax bill – you can read more about how setting up a trust can help you do exactly that here.
Russia and Ukraine, China and Taiwan, bubbles of Covid erupting around the world… it is no exaggeration to say that the world is in uproar and high levels of volatility on the markets are reflecting that. 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 (barely two months after many markets may have bottomed out), you would lock those losses in before your pension had had a chance to recover.
If you are lucky enough to have a very large pension, then there is a chance that buoyant markets might lift your savings above the Lifetime Allowance. This is currently £1,073,100. So if you think that you are likely to reach this by the time you retire, then it would be worthwhile talking to us about the implications of doing so – anything you accumulate above this amount will be subject to a tax charge.
Obviously taking out tax-free cash can help you avoid this if you think you might be nearing this threshold.
Once you've decided whether or not you want to withdraw your tax-free lump sum… you have to consider what you want to do with what is left.
Of course, there is every possibility that you will want to keep paying into your pension. However, bear in mind that if you withdraw more than the 25% tax-free cash from your pension (deemed to be taxable income), you will not be able to pay in more than £4000 per annum going forward. This is significantly below the £40,000 pension contribution annual allowance.
It is more likely, however, that you will want to use your pension as an income. But will what you have put into it provide you with the income that you need? Financial adviser William Bengen famously reconstructed annual investment results from periods such as the Great Depression, World War II and the inflation-riddled 1970s and came up with a maximum safe withdrawal rate of 4%. He has tweaked it a little over the years, but he has essentially demonstrated that if you spend 4.5% of your assets in your first year of retirement and then increase that annual amount every year by the rate of inflation, then your money should last you at least 30 years – all other things being equal.
Whatever you decide will depend on your financial circumstances, what you want to do with the years you have remaining and whatever is happening in the world. At Investment Quorum, we are 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.
Get in touch with us and make sure that your plans are on track – we can tailor whatever investment strategy you have with us so that it meets your retirement needs.
