NEW pension rules taking effect in just a few weeks’ time will give retired people greater flexibility with their savings – and in the process land many with shock tax bills.
Tax charities have warned that those on low incomes without access to detailed advice could be particularly vulnerable to steep tax charges, as concerns grow over the risks posed by the reforms.
Members of defined contribution (DC) schemes aged 55 or over will from April be allowed to take their entire pension pot as a cash lump sum, including 25 per cent tax-free. The remainder will be taxed at the individual’s marginal rate, rather than the current 55 per cent.
The 25 per cent can be taken either in one go or in small lump sums, with the first 25 per cent of each slice tax free.
But even those with “limited means often have complex circumstances and difficult decisions to make” with their pension savings, according to the Low Incomes Tax Reform Group (LITRG), and yet they may not be able to access the advice they need to minimise their liabilities.
“The tax implications of making withdrawals from pensions are hugely complicated, and consideration needs to be given to the individual’s full circumstances – both current and anticipated – in order to guide someone adequately,” said Anthony Thomas, chairman of LITRG.
Public awareness of the amount of pension savings that HM Revenue & Customs can get its mitts on is low, judging by recent research.
Fewer than four in ten people surveyed by Mori on behalf of Hargreaves Lansdown last year knew how much tax could be taken from a medium-sized pension, while just 6 per cent could accurately predict the amount charged on large pension pots.
“All may not be what it seems with pension freedoms; there may be a tax ‘sting in the tail’ for the unwary,” said Brian Steeples, managing director and chartered financial planner at The Turris Partnership in Glasgow.
“Great care is needed in understanding the tax on any withdrawal from your pension fund.”
So what do pension savers need to know? What won’t change is the ability to take the first 25 per cent of a pension pot tax-free. What will be different from April is that the amount taken above that will be charged at the individual’s marginal rate, rather than the 55 per cent rate currently levied.
But research by the International Longevity Centre (ILC) revealed that just 20 per cent of savers understand what the “marginal tax rate” is. It also found that one in ten over-55s wrongly assume that taking all their pension as a single lump sum would minimise their tax liabilities.
Your marginal tax rate is your tax band once all income is factored in, including cash taken out of a pension. Everyone gets a personal allowance, which is the slice of income that isn’t taxed. This is currently £10,000, rising in April to £10,600. Income tax is charged at 20 per cent on the next £31,865 above the personal allowance (falling to £31,785 in April).
Income tax is charged at 40 per cent on income between £41,865 and £100,000 and effectively at 60 per cent on income between £100,000 and £120,000 (because the personal allowance is reduced for every pound of income earned between £100,000 and £120,000). Income above £120,000 is taxable at 40 per cent, with the 45 per cent rate kicking in at £150,000.
The withdrawals taken from a pension above the 25 per cent tax-free amount are charged at your highest marginal rate.
“So for example, if you have a pension fund of £175,000, you can take £43,750 as a tax-free lump sum,” said Steeples. “If you take the remainder of the pension fund as a once-off pension withdrawal, you will suffer 60 per cent income tax on part of the withdrawal and 40 per cent income tax on the majority of the withdrawal.”
The tax you pay on your pension cash therefore depends on the amount you take and your other taxable income for that tax year, which is why smaller withdrawals over several tax periods are more tax-efficient.
If, for instance, you have a salary of £30,000 a year and no income on top of that, you will pay income tax at 20 per cent. But if you also take a £30,000 pension pot in one tax year, you’ll get the first £7,500 tax-free but the rest of it will drive you into the 40 per cent income tax band (with implications for means-tested benefits and credits).
“Understanding the income tax bill attaching to any withdrawals from your pension fund is a critical part of your financial planning process,” said Steeples. “Do not give yourself an unexpected tax bill by thinking the pension freedoms are tax-free.”
The added complication of taking pension cash that’s liable to tax is that it may entail having to deal with HMRC. Basic tax law requires every UK citizen “to advise HMRC of all of their UK income and all of their worldwide income – each and every tax year”.
“Many people think they will not need to have any involvement with HMRC regarding their tax affairs. That is not necessarily the case, and you should be fully aware of your tax liability for any pension withdrawal you make,” said Steeples.
“It is a misconception to think that HMRC will only become involved in your affairs if you are a higher rate taxpayer.”