Updated 03 December 2020
You can now draw out your whole pension pot in one go â at least in theory. But, like drinking a whole bottle of champagne, what might sound fun can end up being a headache. If you donât want a tax-induced hangover, it pays to know your limits.
A pension is far and away the most tax-efficient way to save. Thereâs tax relief on everything you pay in, and also no tax on the investment growth. But what you might forget is that tax does come back into play at the end, when itâs time to take the money out.
Under pension freedom, you now have full access to your defined contribution pension pot. Even better, 25 per cent of it will be tax free. But that means three-quarters of it will be subject to the normal rate of income tax. This is because money drawn from a pension counts as income â itâs not like money in the bank that you already own. But YouGov research published by SavvyWoman shows high levels of confusion surrounding pensions and tax, with nearly 1 in 5 (17 per cent) contemplating drawing out the whole lot at once. As weâll see, such a binge really isnât a good plan.
Suppose you have a pension pot of Â£80,000. You can take Â£20,000 of this straight away and pay no tax on it ever. But now the familiar income tax rules come into play. You can draw another Â£10,600 for the year and pay no tax on that, because thatâs your personal allowance. But anything above that in the same year will be taxed first at 20 per cent, until you reach the next band. Youâll pay 40 per cent tax on everything over Â£42,385 and so on.
It gets even more complicated if you have other sources of income, such as a salary (you donât have to be retired to access your pension, you just need to be 55 or over), rent from properties, or final salary pensions. Everything contributes to the total, so you may find you donât need to draw out very much at all to tip you into a higher tax band. Having saved up your pension tax free for most of your life, you probably donât want that money being suddenly taxed at 40 per cent.
So remember: when it comes to pension freedom, just because you can do something doesnât mean you should. Always keep one eye on your total income level for the year, plan ahead and pace yourself. As with celebrating your retirement, the key to drawing your pension is moderation. A binge on that savings pot may be tempting, but you could end up regretting it in the morning.
Find out more about how to draw your pension at https://www.unbiased.co.uk/Pension-freedom.