Since the new pension freedoms came into effect last April, the majority of people with more modest pension savings, of up to £20,000, have mostly taken their whole pension as cash and paid income tax on the 75% of it that is taxable.
If you’re considering taking the whole of your pension as a cash lump sum, there are a number of things you need to think about before making a decision:
What you should consider
• Taking the whole amount as a cash lump sum is something to consider for people whose pension pot is modest – less than £20,000, perhaps. The money could be used to repay debt such as a mortgage or spend on home maintenance, for example.
• Taking all of the money as soon as you’re able to do so, at age 55, isn’t always a good idea. Even small amounts can grow quite quickly, especially if you keep investing. And, if you take your money early you may have nothing left at retirement other than your state pension.
• Watch out for the tax on a cash lump sum – you could also be over-taxed and have to claim some money back.
• If you do take money out of your pension, consider reinvesting it in other tax-efficient products such as ISAs.
While the majority of people who have taken their whole pension pot as a cash lump sum have had small pots, this is by no means the only option for those in this position.
Before the pension freedom changes came into effect in April 2015, most pension providers insisted that you have a minimum balance of £30,000, or even £50,000, in order to take regular or one-off withdrawals. This has now changed and some providers don’t have any minimum at all.
So, even if your pension pot is only £10,000, you can leave it invested and take it ‘bit by bit’, if that’s what suits you.
Combining smaller pots
Another option with small pension pots is to combine them. Bringing all your pensions together under one roof may save you some money in charges, as well as being easier to manage. But do think twice before you transfer any older pensions with guarantees. These guarantees are often valuable and may be worth paying a bit more in charges to keep. If in doubt, consider taking financial advice from a regulated adviser.
Think about the long term
Before the pension freedoms came into effect in April 2015, only people aged over 60 could take their pension as a cash lump sum.
Although it may be tempting to take your whole pension pot at age 55, remember the money is supposed to see you through your whole retirement. At 55, you might think that you will be able to work forever, but age catches up with most of us at some point. Remember that the state pension on its own may not be enough to maintain your current lifestyle when you’re retired, so keeping some money in your pension until you eventually retire could be of benefit.
Although your pension pot at age 55 may look small, it’s amazing what difference another 10-15 years worth of investment returns and continued contributions could make – although you should always be aware that the value of investments can go down as well as up and you may not get back what you invested.
For some, taking a cash lump sum at age 55 may be the right thing to do from a purely financial point of view. For example, those who are paying interest on debts at a particularly high rate – more than the investment return they can earn on their pension pot – may be better off taking cash and repaying debt.
Those who lose their job may also feel that they have no other option but to dip into their pension pot, particularly if this allows them to continue meeting their mortgage payments until they are back in work.
You could pay more tax than you expected
If you do take a cash lump sum from your pension, you may find that the tax you pay on the taxable part is a lot higher than expected. This is because initial withdrawals are taxed on an emergency ‘month 1’ basis.
Month 1 tax assumes that your withdrawal will continue at the same level every month until the end of the tax year, even although you are only taking a single withdrawal.
For example, if you took £10,000 out at the end of April in one tax year, the Month 1 basis would assume that you were going to earn £120,000 (12 months times £10,000) on top of any other taxable income.
This means you may end up paying an effective tax rate of over 30%, even although you are usually a basic rate or non-taxpayer. Any excess amount of tax can be reclaimed by filling in a tax form if you want to reclaim an overpayment immediately. Alternatively, you can wait until the end of the tax year, when Her Majesty’s Revenue and Customs will automatically calculate and refund any overpayment.
Pensions vs ISAs
Generally speaking, taking money out of your pension to put it into an ISA may not be a good idea. Pensions, like ISAs, are tax efficient, but they don’t form part of your estate for inheritance tax, whereas your ISA savings do.
Some people take their money out of their pension to place in a cash ISA without realising that they had the option to invest it in a cash deposit account within their pension. In most cases, you may be better leaving your money in your pension until you need it – especially if you expect to pay a lower rate of income tax in the future. Why pay a high rate of tax now to access your savings pot, when you could pay less in future?
If you’ve already taken money out of your pension but haven’t yet spent it, consider keeping it in the most tax-efficient savings plan – for example, an ISA.
Alternatively, you could pay it back into your pension if you’re still under 75. There are rules about paying money back into a pension once it has been taken out and limits on the amounts. You need to make sure that you stay within these, or you could pay a high tax charge.
- Even if you aren't earning you have a minimum pension contribution allowance of £3,600 pa including basic rate tax relief, each year until they reach age 75.
- The maximum is generally 100% of earnings up to an annual allowance of £40,000,
However taking certain types of retirement benefit could reduce the amount you are able to pay into your pension to £10,000 per year.
For more information on how your own retirement benefit choices may affect your annual allowance, please speak with your financial adviser.
What else might you do?
For other ways of accessing your pension, see: