As more and more of us make the most of pension freedoms to grab hold of our tax-free cash, make sure you don’t make any of these seven costly mistakes
Take A Moment To Consider These Seven Things As You Rush To Extract Your Tax-Free Cash
Tips To Stop You Wasting Your Tax-Free Cash
Since pension freedoms came into force in April 2015, pension providers have reported an increase in people stripping out tax-free cash from their pension pots, leaving the rest of their funds invested, often from the earliest possible age of 55.
The research suggests some people are using their pension pots as a sort of short-term emergency fund, rather than leaving their money to grow to provide genuine retirement benefits. The long-term effect of this could be quite serious, as it may create a shortage of income in years to come, especially as people are living much longer.
Evidence from Fidelity International indicates that as many as three-quarters of its customers are choosing to take tax-free cash from their pension pots, leaving the rest untouched. Some people with smaller funds are cashing in the whole lot, indicating that with the plethora of changes in pension legislation in recent years, they’re getting their hands on their tax-free cash now in case future changes reverse the flexibility.
Whatever the reason you might decide to draw your tax-free cash, here are seven tax-free cash mistakes to avoid.
1. Failure To Use Other Savings Ahead Of Tax-Free Cash
When you draw tax-free cash from your pension fund, it becomes part of your estate. Once your money is outside your tax privileged pension wrapper, it’s exposed to all the taxes HMRC can throw at it.
Generally speaking, it’s worth considering using your taxable savings first, then your tax-free savings such as ISAs before drawing tax-free cash from your pension pot. This way, your pension money is sheltered from tax for as long as possible, including it being passed onto future generations free from Inheritance Tax.
2. Taking More Tax-Free Cash Than You Need
Just because you can draw up to 25 per cent of your pension pot as tax-free cash, it doesn’t mean you should.
Many pension schemes allow you to phase the drawing of your retirement benefits, enabling you to shelter your money inside your pension tax wrapper until you really need it. After all, there’s no point in whipping out your tax-free cash simply to reinvest it outside of your pension and pay tax on it if you don’t need to.
If your pension provider doesn’t allow you to draw your tax-free cash in a flexible manner, then consider moving your pension pot to one that does, subject to checking charges and losing out on any guarantees and benefits in your current scheme.
3. Drawing Tax-Free Cash At The Wrong Time
If you need to draw your tax-free cash for a particular purpose at a specific time, then fine. But if that time co-incides with a fall in the value of your investments, you’ll be locking in a loss. If it’s possible, it might be a better bet to use other sources of money, giving your pension fund an opportunity to recover.
If you’re fortunate to have a larger pension pot, taking your tax-free cash could mean you avoid going over the Lifetime Allowance limit and paying penal tax rates. But it’s not an automatic decision, for whilst you might avoid a tax bill in the short term, you could miss out on future tax-free growth, and the fact you could be severely limited in future pension contributions.
4. Doing Nothing With Your Tax-Free Cash
If you’re simply taking your tax-free cash to invest it elsewhere, perhaps in a bank account, it could be a very expensive exercise. The returns you make could be subject to tax, whereas they might well have been tax-free within your pension pot. The result is that your returns could be up to 45 per cent lower if you reinvest the money in exactly the same area, if you pay Income Tax at the highest rate.
The tax-free cash withdrawn, together with any appreciation, will be included in your estate for Inheritance Tax purposes, which could see 40 per cent of it disappear on your death. Pensions are not subject to Inheritance Tax.
Often forgotten is the fact that owning assets in your name may affect your ability to claim certain benefits and allowances, perhaps in relation to long-term care, whereas money in pension funds is generally excluded from any assessment.
Here’s the point. You can often invest in exactly the same investments either inside or outside of a fully flexible SIPP or SSAS. However, your returns are likely to be higher within a SIPP or SSAS tax wrapper, because the money you make on your investments is largely earned tax-free.
5. Taking Tax-Free Cash When You Don’t Pay Tax
If you don’t have sufficient total income to use up your personal Income Tax allowance (£11,000 for 2016/2017), it may not make sense to take your withdrawal totally as tax-free cash. Instead, you may wish to consider taking a pension withdrawal that’s partially taxable.
By way of example, if you have £6,000 of unused personal allowance, you could draw £8,000 from your pension fund and pay no tax. The first £2,000 would be treated as your tax-free cash (25 per cent of your withdrawal). The balance of £6,000 would be tax-free too, making the most of your unused personal allowance.
You will, of course, need to be invested in a pension scheme that allows the flexibility of such withdrawals.
6. Not Claiming The Full Tax-Free Cash Amount
If you’ve been a member of a defined contribution (money purchase) occupational pension scheme or a Section 32 Buy Out Plan from before 2006, you might be able to take advantage of ‘protected tax-free cash’. The rules are pretty complex but it could mean you’re entitled to draw more than 25 per cent of your pension pot as tax-free cash.
7. Not Drawing Tax-Free Cash When You Want The Maximum Income
If you don’t need your tax-free cash and you’re looking for the security of a fixed retirement income, buying an annuity with all of your pension pot is a possibility. But there could be a better way to boost your income.
On the face of it, drawing the maximum tax-free cash from your pension will mean there’s less money left in your pension pot to buy your annuity. However, when you receive your tax-free cash, you could purchase a lifetime annuity with it. The rate you receive is likely to be similar to the rate you’d receive from buying a pension annuity, but part of your lifetime annuity will be tax-free, as it’s deemed to be a return of your capital. The net result could well be a higher fixed income for the rest of your life.
In this situation, it would be wise to consult a specialist, not just to make the most of the taxation treatment of the different types of annuities, but also to ensure you secure the highest annuity rate which can often be enhanced for a variety of reasons, including lifestyle and ill-health.
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Over time, charges can wipe out a huge part of your fund. We like AJ Bell because there are no set-up costs. If you hold passive funds, which is our preference, or shares, investment trusts, EFTs, gilts or bonds, you pay one small fixed fee no matter how large your fund. And when you come to draw your benefits either as occasional drawdown or UFPLS payments, there's a small charge for the whole year no matter how many times you access your money (many SIPP and SSAS providers charge more than this for each payment). However, you should always compare charges in detail, because AJ Bell could be more expensive than other providers, depending on the type of stockmarket assets you hold.
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