New pension rules: don’t forget about tax

by Paul Northmore, Managing Director

The new pension rules announced last year come into effect on 6th April 2015 – “Freedom Day”.  

From that date, if you are 55 or over you can withdraw your entire ‘defined contribution’ pension pot as a cash lump sum if you wish.  (‘Defined contribution’ means how much you receive depends on what you’ve paid in.) 

Many are tempted by the new freedom.  A recent survey by The Pension Advisory Service and TD Direct Investing indicated that 24% were planning to take at least half of their pension pot as cash. 

But there are some important tax considerations.

The new tax rules for pensions

75% of each lump sum you withdraw is subject to tax – and your pension pot withdrawals are classed as ‘income’ and taxed by the same rules.  This means:

• You pay no tax on the first £10,000 income you receive in a tax year
• You pay 20% tax on your income between £10,000, up to £41,865
• You pay 40% tax on your income over £41,865

So if you are planning to take out a large lump sum (or several smaller sums) in one tax year, you could find yourself stung with a high tax bill if some of your pension withdrawal falls into the 40% tax bracket.

Note, these limits apply per tax year – hence it’s more tax efficient to withdraw smaller amounts over more tax years.

‘Emergency coding’ for pension taxation

If you are planning a large lump-sum withdrawal in April and you don’ t have a tax code, be prepared to be taxed heavily, and potentially have to wait for a year to get back any overpayment.

• However much you withdraw from your pension pot, the tax due must be paid when you make the withdrawal - not at the end of the tax year.
• If you already have a tax code, you can tell the pension provider when you make the withdrawal, so it’s taxed at the correct rate.
• If you don’t have a tax code you’ll be put on ‘emergency coding’.  This code is based on the assumption that you’ll be withdrawing the same lump sum every month – and hence the tax deducted will be much higher, and much more than you should actually pay.
• At the end of the tax year you can complete a rebate claim or a tax return and HMRC will pay back any overpayment.

‘Guidance’ is not enough

Whatever you are intending to do with your pension pot, remember the saying, “when it’s gone, it’s gone”.

Your pension pot needs to fund the whole of your retirement – and of course statistically we are all living longer. 

The government’s Pension Wise service is intended to give ‘guidance’ about pension choices.  But importantly, it can’t give you advice about investments – and for many people, investments are going to be a key part of making their pension pot work hard for them, so they can enjoy a long and comfortable retirement.

So before you rush to make a cash lump-sum withdrawal, consider the tax issues, and have a clear plan about how you will use or invest your money. 

And if you need independent advice to help you explore the best options for your situation, please get in touch.