4th March 2019
WEALTH at work, a specialist provider of financial education and guidance in the workplace supported by regulated advice for individuals, recently carried out a poll of over 70 employers and found that 91% of them believe that employees do not understand the tax rules when withdrawing money from their pension.
This is particularly concerning as the Office for Budget Responsibility (OBR) announced last year that the Treasury will net an extra £400m as a result of people paying tax on their pension withdrawals which is 50% more than forecast, and a recent report by the Pensions Policy Institute showed that individuals could end up paying 200 times more tax depending on how they decide to access their retirement income.
Jonathan Watts-Lay, Director, WEALTH at work, comments;
“We polled over 70 employers, and it is incredibly concerning that they believe their employees don’t understand the tax rules when withdrawing money from their pension, as it is very easy to end up paying unnecessary tax.
Typically only the first 25% of a defined contribution pension is tax free, and the remaining 75% is taxed as earned income. Some basic rate tax payers have taken their pension as a cash lump sum and ended up having to pay 40% tax on some of their pension as they became a high rate tax payer for that year.”
He adds; “It is possible to save significant amounts in tax by making sure pension withdrawals don’t take individuals out of their tax band. For example, it may be tax advantageous to take income from non-pension savings first such as ISAs and Shares, and with careful planning it may be possible to pay no tax at all which we have highlighted in our examples below.”
Watts-Lay continues; “It is really important that people take the time to understand the tax rules when withdrawing money from their pension. Guidance is available from Pensions Wise but will only cover the options for your pensions and won’t consider other sources of retirement income. Many employers also offer financial education, guidance and regulated advice services for their employees to help them understand all of their income options at-retirement, including the tax implications of accessing them.
After all, it is becoming increasingly recognised that as many people spend all of their working life saving for retirement, they need help understanding how to make the most of their retirement income options.”
Examples which show how it may be possible to pay little, or no tax at-retirement with careful planning.
All of the examples outlined below have similar situations to make it easier to see how the process works, but examples 1 and 3 are not yet eligible for their State Pension and example 3 has a smaller pension pot, but more taxable savings. All examples assume stocks and shares ISA returns of 5% and interest available on taxable cash deposits of 1.4% gross.
Please note – all examples assume no additional income from earnings in the tax year and the personal allowance for tax year 2019/2020.
Example 1 – Peter
Peter is age 60. He has a defined benefit (DB) pension (also known as a final salary pension) which will pay £9,000 p.a., a defined contribution (DC) pension fund (also known as a money purchase pension) worth £300,000, stocks and shares ISAs worth £50,000 and £10,000 held in cash. He is planning to retire in April 2019 and would like to generate an initial annual income of £20,000 p.a. net and retain the £10,000 as an emergency cash reserve.
By utilising his ISA and taking income through his pensions, it is possible for him to do this without paying any tax in year one (even though £20,000 is significantly above the personal allowance of £12,500 for 2019/20).
Peter can withdraw the £2,500 (5%) return from his ISA leaving £17,500 to find. He has a personal allowance of £12,500 so he does not need to pay tax on the £9,000 from his DB pension and consequently will have £3,500 of unused allowance available.
He therefore needs a further £8,500 to have the £20,000 income he is looking for. To be able to do this he could take benefits on £20,000 of his DC pension, take 25% tax free (£5,000) and then draw £3,500 as income from the £15,000 available. By doing this he will have the £20,000 he is looking for tax-free.
Example 2 – Mary
Mary is in exactly the same financial position as Peter, but eligible for the full new State Pension. As the combined income from her DB scheme and State Pension will be higher than the personal allowance, she will need to pay some tax, but will not need to pay any further tax up to the £20,000 annual income she is hoping for.
Mary has a personal allowance of £12,500. The combined income of £9,000 from her DB pension plus £8,296 new State Pension gives her a gross income of £17,296. Income tax payable on this would be £959, leaving a net income of £16,337.
To achieve her aim of an income of £20,000 a year, she can supplement this with £2,500 return from her stocks and shares ISA and £1,163 tax free cash from her DC pension fund. To do this she would need to draw benefits on £4,652 from her DC pension, £1,163 (25%) can be taken as a tax free cash lump sum but the remaining £3,489 would remain in her pension fund with the potential to grow.
Example 3 – David
David, age 60, is looking to retire in April 2019. He is in a similar position to the examples above except that he is not yet eligible for his State Pension, his DC pension is £200,000 and he has taxable cash deposits of £100,000 as well as an ISA of £50,000.
To achieve his aim of an income of £20,000 a year tax free, he could use the £9,000 from his DB pension and £3,500 from the taxable part of his DC pension fund to use up his personal allowance (£12,500). He would need to withdraw £4,667 of his DC pension with £3,500 (75%) in taxable income and £1,167 (25%) would be paid as a tax free cash lump sum (£3,500 + £1,167 = £4,667).
This could be supplemented with £1,400 interest from his savings (£100,000 at 1.4%), which would not be taxed because the starting rate for savings income is £5,000. As it is better to leave as much money as possible in the tax efficient wrappers of ISA and pension, David may choose to withdraw the remaining £4,933 needed from his cash deposit to make up the £20,000 he is looking for.
With all these examples, the individuals are paying the lowest amount of possible tax, keeping their ISAs at the same level (assuming the stocks and shares ISA grows by 5% per year) and withdrawing the remaining amount needed in a tax efficient manner from their pensions and other savings and investments.