A When the pension rules were overhauled six years ago, the most eye-catching – and controversial – new freedom given to pension savers was the ability to cash in their pension in one go. This led to fears that the UK would be a nation of impoverished pensioners, who recklessly frittered away their life savings for cruises and home renovations.
Those fears have been largely unfounded, mostly because people accessing their pension in the last decade or so have been like you – making sensible decisions weighing up how much guaranteed income they have from state and private pensions and what their pension pots will enable them to do in retirement.
Data from the Financial Conduct Authority, published last year, found that nine out of 10 pensions that had been fully withdrawn in the 2019-20 tax year were valued at £30,000 or less. Almost a quarter of a million of the pension pots that were cashed out were valued at less than £10,000, representing almost 60 per cent of all pots cashed in. Only 346 pension pots cashed in were valued above £250,000. Hardly the display of profligate pensioners splurging their savings away.
You can encash your pension from the age of 55, though this is increasing to 57 by 2028. It’s technically possible to do so before the age of 55 but a word of warning – there is a huge 55 per cent tax penalty for accessing your pension before 55, and the companies offering to help you ‘unlock’ your pension often charge eye-wateringly high charges of 30 per cent meaning that a huge chunk of your savings would never reach you.
That aside, if you’re over 55 tax is still one of the main considerations that should factor in your decision to cash in your pension in full. When you close your pension account and take your fund as cash, the first 25 per cent of your cash will be tax-free, and the rest will be taxed at your highest tax rate (by adding it to the rest of your income). The rate you pay will depend on your income for that year and where you live, as income tax rates differ in Scotland and the rest of the UK.
If the amount you take out of your pension, combined with the rest of your income in that tax year exceeds £150,000, you’ll be charged the top rate of 45 per cent in England, Wales and Northern Ireland, and 46 per cent in Scotland. You’ll also forego any of your personal allowance (the amount you can earn tax-free) once your income exceeds £125,140, meaning that you’ll be taxed on all the income you get from cashing in your pension (aside from your 25 per cent tax-free lump sum).
Spreading withdrawals over several years can minimise your tax bill and mean that your tax-free entitlement is spread over several years. Which? has created a calculator, at which.co.uk/pensioncalc, to help you understand your potential pension tax bill.
You might encounter another tax wrinkle. When you cash in your pension, it's likely that you'll end up paying emergency tax because your pension company doesn’t know your tax code or about any other income you might earn. Therefore, you could be taxed on a ‘Month 1’ basis, which assumes that the pension income you get from cashing in is just 1/12th of your annual income. If you withdrew £30,000 in one go, you’d be taxed as that your annual income is £360,000, causing you to overpay tax. You can apply to HMRC to get these rebated, which should take four weeks.
Your ability to take your pension out in one go will also depend on your pension company. Not all pension schemes offer this option, even six years after the rules were put in place, although this is particularly acute in workplace pensions. Some pension companies might require taking financial advice before you cash in, and you’ll need to pay an adviser a fee.
Remember that any savings you leave behind that are in a defined contribution pension can be inherited by anyone you nominate. They can take it as an income, or as a lump sum, and pay tax at their own personal ‘marginal rate’. The good news is that your pension does not form part of your estate for inheritance tax purposes, so won’t be ‘double-taxed’ when you die. However, when you cash in your retirement savings, they’re no longer held in a pension and count towards your inheritance tax allowance. This means your heirs could end up paying tax of up to 40 per cent on any part of it they inherit.
Gareth Shaw is Head of Money at which.co.uk