Updated 03 September 2020
You’ve saved up plenty in your pension – good. You’ve put the phone down on the pension scammer – very good. But then you get careless, and end up making a very costly pension blunder. Here’s how to avoid it.
Consider this. You’ve got a large sum of money, in a place when it earns a high rate of growth, where it’s easily accessible and where, most importantly, it’s protected from tax. You’ve spent years of hard work building up this fund.
Then someone suggests you take the money out of this safe and profitable place and stick it in an ordinary bank account, where it won’t earn half so much interest, and that in the process you give the tax man hundreds or thousands of pounds. Most people would answer with the words, ‘Do I look like I was born yesterday?’
Yet, incredibly, a lot of people are now doing just that.
Grab the cash and run?
In a survey of 800 of its customers, Royal London found that nearly 70 per cent wanted to cash in their whole pension pot in one go. It’s now possible to do this under pension freedom – in the same way that it’s ‘possible’ to perform a three-point turn in the fast lane of the motorway. Even worse, 23 per cent of those withdrawing their pots were planning to move the money to an ordinary bank account.
Why is it such a no-no? Two reasons: interest and tax. We’ll take these in order.
A pension (of the money purchase kind) has always been a sort of savings account, just with unusually high rates of long-term growth and (previously) heavy restrictions on how and when you could access the money. But a lot of these restrictions have now been lifted, meaning that a bank account has almost no advantages over a pension, and plenty of severe disadvantages. Effectively, it would be like trading in a sports car for a three-wheeled van.
The big tax hit
But by far the bigger issue is tax. Many people who are withdrawing their whole fund seem unaware of how much tax they will pay in the process. Only 25 per cent of your pension pot can be withdrawn tax free, with the rest taxed at your marginal rate. Royal London estimates that on a pot of around £15,000, the initial tax charge would be over £3,000. Remember, this is money that has benefited from tax relief for the entire savings term – withdrawing it in one go could render all those years of saving meaningless.
How to pay less tax on your pension
Well, you may ask, what’s the alternative? If I’m going to be taxed anyway, why can’t I take my whole pension at once? Because of the way tax works. Like any earner, you still have a tax-free personal allowance in retirement, so if you stay within this (or close to it) then you’ll pay no (or little) tax. In other words, a series of smaller withdrawals from your pension should net you far more money than taking it in one go.
As to where you should keep the money, there’s absolutely no logic in stashing it in a bank account. Under pension freedom, pensions themselves can work very much like bank accounts (although you should never confuse the two). Even if your current pension fund doesn’t allow the flexibility you want, you should be able to switch to another pension fund that does – often within the same plan.
So, to recap:
The key message to remember is this. Although you can withdraw from a pension in a similar way to a bank account, there is a crucial difference. Money withdrawn from a pension pot counts as income for that year (unlike money in a bank account, which has already been taxed except for any taxable interest). Therefore, always be careful about how much you take from your pension in one go.
It’s certainly an exciting new world for people approaching retirement age. But don’t let the freedom go to your head: think before you throw away a big chunk of your life savings.
To find out how to keep the most money for yourself in retirement, talk to a financial adviser. You can book a free pension check with one here.