A Stockport based firm of Chartered Financial Planners has warned that individuals who access their pension funds without proper planning risk paying much more tax than is necessary.
The “pension freedoms” launched by the Government in 2015 allow people to take as much as they like out of defined contribution (DC) pension funds once they reach the age of 55 but, according to Prest Financial Planning, taking too much in one go can lead to an unplanned and entirely avoidable tax bill.
Mike Walker, a financial planner at the Stockport firm, said,
Her Majesty’s Revenue and Customs has recently forecast that it will receive an additional £5.1bn in tax by April 2019 as a result of the pension freedoms. That might be good news for the government deficit but much of this tax will probably be paid unnecessarily.”
Taking a large pension fund as cash in one go can, in some cases, lead to income tax bills of tens or even hundreds of thousands of pounds. Even in smaller cases, which make up the majority of funds that are cashed in, significant tax savings can be made by planning how and when withdrawals are made.
Twenty-five per cent of the value of a DC pension plan can usually be withdrawn entirely tax-free. The remainder is subject to income tax at the point at which you take it out – so if a taxpayer takes too much in one go they could end up paying higher (40 per cent) or even additional (45 per cent) rate tax on some or all of it.
Prest Financial Planning gives the theoretical example of an individual who, at the age of 55, was still working for a salary of £30,000 per year and decided earlier this year to cash in an old personal pension worth £40,000 in order to fund home improvements. If that individual had cashed in the entire fund in one go before 5 April, it would have pushed them into the higher rate income tax bracket and they would have paid £9,000 in tax on their pension fund.
Alternatively they could have taken their tax-free 25 per cent lump sum (£10,000) along with half of the remaining £30,000 pension fund before 5 April 2018 and waited until the beginning of the new tax on 6 April 2018 to take the second half. In this case there would have been no higher rate tax payable and the total tax bill would have been £6,000 – a saving of £3,000.
There are potentially worse things than an unnecessary tax bill: by cashing in a pot worth more than £10,000 the individual in the example above would have triggered something called the Money Purchase Annual Allowance (MPAA), which would have restricted the amount they could contribute to a pension in future to just £4,000 per year. This might potentially have been a big issue for someone who was still saving hard for eventual retirement some years away and was just cashing in part of their pension portfolio in order to release some capital to meet a particular need.
Mike Walker continued, “
There are, potentially, other ways that money could be raised more tax-efficiently and without triggering the MPAA. Individuals may, for example, be able to take a portion of the tax-free cash available from a larger pension pot, while leaving the taxable element of smaller ones untouched.
“These are really complex issues and are best addressed as part of a comprehensive lifelong financial plan. We would always recommend speaking to a suitably qualified adviser before accessing any element of your pension savings – pensions nowadays can be fantastically tax-efficient but also fiendishly tricky, and a modest investment in advice can save you so much money in the long term.”