Hitting 55 and the temptation of tax-free cash

Pension Freedoms came into effect in April 2015. It gave everyone age 55 and over much more flexibility with their pensions, enabling them to withdraw as much or as little as they wish.

In June this year, the Financial Conduct Authority published a final report on the Retirement Outcomes Review, designed to investigate Pension Freedoms impact and the public’s response. It clearly proved very popular; data from HMRC shows that 1.8 million people have made withdrawals totaling £17.4 billion, but some people are making rash decisions.

The danger of acting on impulse

The FCA’s report found that twice as many pensions have been used to make flexible withdrawals than purchase an Annuity, a trend we’re likely to see increase in future. The problem is that 37% of people making withdrawals are doing so without financial advice. Is a provider’s retirement information pack enough to make an educated decision? We would argue not!

It seems many people want to get hold of their 25% tax-free cash with the path of least resistance, which means staying with their existing provider. In fact, a staggering 94% of non-advised people taking income didn’t switch.

Your existing pension may have been suitable saving towards retirement (presuming it has been reviewed by an adviser recently), but you shouldn’t assume the same scheme is appropriate to take income from. Think about skiing; you get the ski lift up the mountain and ski back down. You could stay sat on the lift, but it’s not the best way down the slope!

Several older pensions don’t permit flexible income, known as Flexi-Access-Drawdown, but even if they do, the associated charges can vary significantly from one provider to another. The FCA point out that by switching from a higher to a lower cost provider, you could increase your annual income by as much as 13%.

Pension Freedoms has opened so many opportunities; when you’re tempted to take your tax-free cash, here are the questions you should be asking:

1. If I take tax-free cash, what now?

Your pension fund will remain invested. The problem is that one in three people taking income are completely unaware what it’s invested in. Worse still, one in three taking income without advice are only ‘invested’ in cash.  Some providers are even defaulting funds into cash, or cash-like assets when people enter Flexi-Access Drawdown without providing investment instructions.

The effect of inflation is a huge hidden cost; over time the buying power of your pension will be eroded quite significantly. As the FCA explain: “holding funds in cash may be suited to consumers planning to drawdown their entire pot over a short period. But it is highly unlikely to be suited for someone planning to draw down their pot over a longer period.”

2. What level of income is sustainable?

AJ Bell conducted some research recently; it showed that 41% of people are withdrawing more than 10% of their entire pension fund each year. Even allowing for an optimistic investment return, their pension is likely to run out after just eight years.

Also, consider that on average, across the country, lifespans are increasing; with the potential to retire as early as 55, you could be relying on your pension income for 30 or 40 years! By dipping in and making withdrawals without a plan in place, there’s a very real chance you’ll run out of income in later life.

3. What about tax?

Since Pension Freedoms, withdrawals above your 25% tax-free cash are added to your other income in the year, and Income Tax is applied. The problem is the PAYE system that calculates tax payable isn’t really designed to take into account irregular lump sums.

Often when taking ad-hoc withdrawals, especially without advice and planning, you may find you pay much more Income Tax than necessary and have to reclaim it from HMRC; a time-consuming process.

4. Do you want to leave a legacy?

If you’re planning on passing some wealth to younger generations, pensions are the perfect vehicle, as when you die any remaining fund is paid directly to your nominated beneficiary. A big plus is that pensions are usually exempt from Inheritance Tax.

It’s a lot to consider…

If you, or someone you know, is nearing 55 and are tempted to take tax-free cash you must consider the implications. Point them in the direction of this article, or better still, point them in the direction of one of our expert financial planners; after all, advice is unique and dependent entirely on your circumstances.

Don’t rely on provider retirement packs (or Terry at the golf course for that matter) to make such important decisions. Amass all the facts; the opportunities and potential threats, and enjoy your retirement safe in the knowledge you are well prepared.

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