When it comes to accessing retirement savings, it seems that there are a lot of mistakes being made. Recent research has found that many don’t understand income drawdown but are still using it to access their pension without getting regulated financial advice or shopping around first, and over a quarter of over 55s are unaware of tax on pensions if they take the money as cash.
WEALTH at work has looked at some of the pension mistakes they have seen individuals make to highlight where employees facing retirement may need support.
1.Not shopping around
The vast majority (94%) of individuals who go into income drawdown do so without taking regulated financial advice, and accept the drawdown scheme offered by their existing pension provider without shopping around first. Without shopping around, employees could be at risk of not getting the best deal and end up with potentially less money every month in their pocket in retirement than could have been the case. For example, the charges may be higher than alternative options and the choice of investments may not be appropriate for their needs.
For example, Which? found last year that the difference between the cheapest and most expensive drawdown plans was a staggering £12,000 lost in charges over a 15 year period.
It is important for employees to understand that it is possible to get regulated financial advice and receive help managing the choice of investments, for similar fees as some non-advised products.
2. Withdrawing cash for it to sit in a bank or savings account
Some individuals are taking money from their pension just to put into their bank account or other savings and investments. This may not be a wise strategy as by doing this, they will lose out on the valuable tax benefits available in the pension scheme, meaning that they are at risk of paying too much tax and of missing out on the benefits of staying invested in their pension for longer.
For example, if someone took £20,000 from their pension they could receive the first £5,000 (25%) tax-free. The remaining amount would then be taxed as earned income, which for a basic rate tax payer would result in a tax charge of £3,000, leaving them with £17,000 net of tax. If this was then deposited in a savings account, they would then only be receiving interest on this lower sum (£17,000 rather than £20,000) and the money would also form part of their estate for inheritance tax purposes.
It could be wise for employees to consider leaving the money invested in their pension fund and accessing it when it is actually required. By keeping the money in the pension, it keeps its tax-free status. They can also benefit from the present inheritance tax rules because pension funds do not form part of your estate for tax purposes.
3. Not using taxable savings for income
Some individuals are taking income from their pension when instead they might be better off using their other savings which aren’t growing tax free, and are liable for income tax and inheritance tax.
For example, if someone has a variety of pensions, investments and other assets, if they decided to take money out of their defined contribution (DC) pension as income, it would be taxed. It might be better to use their taxable assets such as savings, shares and cash as income, and leave their pension to grow tax-free until needed.
When deciding how to access retirement income, it’s important for employees to understand that it’s not just about pension savings. All savings and investments, whether they be pensions, ISAs, or shares, should be considered to make sure they are being used in the most tax efficient way.
4. Taking pension income when it isn’t really needed
There may be a good reason for taking cash from a pension but some individuals are taking income from it whilst they are still working. They would probably be better off leaving it until retirement, and therefore making best use of their available tax allowances. Taking pension income whilst still working is likely to result in a tax charge as shown below:
For example, someone with a salary of £25,000 pays 20% tax. If they cash in their pension pot of £20,000, only 25% of the pot is tax free, and the remaining £15,000 is classed as income and taxable at 20%. Therefore, instead of £20,000, they only receive £17,000, as £3,000 is paid in tax.
It’s important for employees to understand the tax implications of taking money from their pension; For example, many don’t realise that usually only the first 25% taken is tax free and that the remainder is taxed at their ‘marginal’ rate – the rate of income tax paid when all sources of income are added together. So by taking income from their pension when their overall income is lower, such as in retirement, employees can minimise the tax that would be due. It should also be remembered that a pension is intended to fund retirement, not to supplement a salary.
5. First time higher rate taxpayer
Some individuals who have never been a higher rate tax payer, are suddenly finding themselves paying 40% tax when they cash in their pension in one go.
For example, if someone who is normally a basic rate tax payer and earns £40,000 a year, decides to take retirement and cash in their DC pension pot of £40,000 in the same tax year; 25% of the pension (£10,000) would be tax free, but tax would be due on the remaining £30,000. Their taxable income for that year would then be £70,000 (£40,000 salary + £30,000 pension), meaning that they would become a higher rate tax payer. Given current tax thresholds (2019/20), £20,000 would be taxed at 40%, creating a total tax liability of £10,000 on the pension.
Unless employees urgently need the money, they might be better off staggering their pension withdrawals over a couple of tax years to avoid unnecessarily becoming a higher rate tax payer, or waiting until the next tax year before accessing their pension.
Jonathan Watts-Lay, Director, WEALTH at work, comments; “It can be daunting for employees when deciding what to do with their pension and as we have highlighted it can be far too easy for them to make costly mistakes. Most have spent their working life saving into their pension, and this is too big a decision to let them sleep walk into it.”
He adds; “Many employers are now seeing the benefits of putting robust processes in place to support their employee’s at-retirement. This includes offering services such as financial education seminars and one-to-one financial guidance over the telephone, in the months or even years before retirement, as well as facilitating an introduction to a regulated financial advice firm which has been through a thorough due diligence process. This should cover key aspects including the regulatory record of the advice firm, the qualifications of its advisers, its pricing structure and ideally a firm which is a workplace specialist. This approach should ensure an improved retirement process leading to better outcomes for all.”