11th February 2021
Latest figures from HMRC have revealed that 360,000 people withdrew from their defined contribution pensions throughout October, November and December 2020 which is a 10% increase on the same period last year.
However, there are a lot of mistakes which can be made when taking money from your pension, whether that be paying unnecessary tax, under estimating how long you will need your pension to last, or even being scammed.
WEALTH at work, a specialist provider of financial education, guidance and advice, has looked at some of the decisions they have seen people making to highlight why these might not have been the best choice for them.
What NOT to do with your pension in 2021
1. Withdrawing from pension early when other options are available
It can be really tempting for those aged over 55 to access their defined contribution pension early if they have an urgent need for cash, especially if they have been made redundant, or are facing a reduced household income. However, there are significant risks if you take money out of your pension without seeking appropriate financial guidance first, such as paying more tax than you need to, and not having enough savings for your retirement.
Whilst you may really need the cash at the moment, you will also need money in your retirement, so it is important to consider all of your options if you are struggling to make ends meet, such as the government-backed mortgage holiday and debt repayment deferrals, or using alternative savings to replace any lost income, and weigh up the best option for you.
2. Not shopping around
The vast majority of people are now choosing to use income drawdown instead of an annuity for their pension income, but (94%) of people who go into income drawdown simply accept the drawdown scheme offered by their existing pension provider.
It is crucial that people shop around to make sure they are getting the best deal. For example, Which? found last year that the difference between the cheapest and most expensive drawdown plans for a £250,000 pot was a staggering £12,300 lost in charges over a 20-year period.
3. Withdrawing cash to put in the bank
Some people are taking money from their pension just to put into their bank account or other savings and investments, but they may not be aware that by doing this they will lose out on the valuable tax benefits available in the pension scheme. It might be better to leave the money invested in their pension fund where it keeps its tax-free status and is more likely to keep pace with inflation, and withdraw when it is actually needed.
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 mean 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.
4. Paying unnecessary tax
There are a number of tax considerations to be aware of when withdrawing from defined contribution (DC) pensions. Firstly, up to 25% of a pension pot can be received as tax-free cash, however anything beyond this is potentially taxable at 20%, 40% or 45%.
Also, when someone draws money from their pension beyond their tax-free cash entitlement, in most cases a money purchase annual allowance is introduced. This means an annual limit of £4,000 will apply to all future pension contributions, instead of the usual £40,000. If contributions beyond this limit are made, a tax charge will be due. This could be significant for those who are not yet retiring and are continuing working and contributing into their workplace pension scheme.
For many, other savings and investments may be a better source of short-term cash than pensions as it can help to avoid unnecessary tax being paid and allows the pension to grow in a tax-free environment.
5. Considering all savings you may have
When deciding how to access retirement income, it isn’t just about pension savings. It is important to look at all savings and investments, whether they be pensions, ISAs, or shares, to make sure they are being used in the most tax efficient way.
Instead of taking money from their pension some people might be better off using their other savings which aren’t growing tax free, and are liable for income tax and inheritance tax.
In addition, ISAs can be a good way to supplement retirement income without paying tax as whilst they grow tax free there is no tax charge when withdrawing so they can help supplement tax free income.
6. Underestimating how long you will live
Before withdrawing from your pension, it is crucial to think about if you will have enough money to last throughout your retirement. Most people live longer than they expect to, and so may underestimate how long they think their savings need to last. For example, The Institute for Fiscal Studies found that those in their 50s and 60s underestimate their chances of survival to age 75 by around 20%, and to 85 by around 5% to 10%. Before accessing their pensions, individuals need to consider if they will have enough money to last throughout retirement.
7. Losing life savings to pension scams
Individuals getting scammed out of their retirement savings is a real issue. A report by Action Fraud found that pension scams had become one of the most common types of fraud to occur last year and that £30.8m has been lost to them over the past three years. In addition, The Pensions Regulator (TPR) revealed it was investigating over £54m worth of lost pension savings, in cases affecting 18,000 savers. However, the FCA warned that this number is likely to be much higher.
Whatever you’re planning to do with your retirement savings, it’s vital to check whether the company that you’re planning to use is registered with the Financial Conduct Authority (FCA). You can also visit the FCA’s ScamSmart website which includes a warning list of companies operating without authorisation or running scams.
8. Not asking for guidance or advice
You don’t have to do this alone, and there is help and guidance available. You can visit www.pensionwise.gov.uk and speak to your employer about any support that they provide, such as financial education and/or access to regulated financial advice.
Jonathan Watts-Lay, Director, WEALTH at work, comments;
“Pressure on household income caused by the pandemic, is making it very tempting for those over 55 to reach for their pension savings to supplement their income. Redundancies are also leading to many individuals deciding to retire early, and therefore access their pension for perhaps the first time. However, deciding what to do with your pension is possibly one of the biggest financial decisions of your life, as you have spent most of your working life saving into it, and it might need to last more than 30 years. So working out how you are going to take money from it needs to be carefully thought through and it is important to consider all your options if you are struggling to make ends meet.
There are a lot of mistakes which can be made, and there is a lot at stake, but with some thorough planning you can make sure that you don’t pay unnecessary tax, use the right assets for income at the right time, and ultimately make educated decisions on what is right for you. If you are not sure, or need help with understanding your options, it is important that you do your research and get some help if needed.”
He adds; “Many organisations recognise that their employees may need help with their finances, especially through this difficult period and are putting support in place. It is worth speaking to your employers to find out what help is available.”