Since April this year, it has been possible to withdraw funds from your pension much more flexibly and, judging by reports from pension companies, many thousands of people have already been taking advantage of these new freedoms. Great news!
I do however have some concerns that some retirees who, when opting for flexible access to their funds rather than a traditional annuity, will misjudge investment returns, or their own longevity, and risk running out of money. Specialist advice in this area really is essential.
There have also been numerous articles in both the local and national press, highlighting the new opportunity to use your existing pensions to fund alternative investments. These might include starting a business or purchasing a buy to let property, for example.
In practice, the tax consequences of making a large withdrawal from your pension fund may make some of these ideas unattractive. Above an initial 25% of the pension fund that can generally be withdrawn tax free, further payments will be taxed at your marginal rate of income tax. This means that for higher and additional rate taxpayers, achieving a further £1 of income above the 25% tax free payment (plus the £10,600 that falls within your Personal Allowance) can prove extremely expensive.
The table below summarises the total withdrawal from pension funds that must be made to achieve an additional £1 payment, net of tax.
|Marginal Rate of Tax||Gross Withdrawal||Net Payment||Income Tax Paid||Income Bands (After Personal Allowance of £10,600)|
|Basic Rate Band – 20%||£1.25||£1||25p||£0 – £31,785|
|Higher Rate Band – 40%||£1.67||£1||67p||£31,786 – £100,000|
|Higher Rate Band – 60%*||£2.50||£1||£1.50||£100,001 – £121,200|
|Higher Rate Band – 40%||£1.67||£1||67p||£121,201 – £150,000|
|Additional Rate Band – 45%||£1.82||£1||82p||£150,001+|
* The effective rate of tax is 60% for income between £100,000 and £121,200 due to the tapered withdrawal of the Personal Allowance.
But the immediate position, when you receive the payment, could actually be worse due to the way the tax system operates in relation to ‘one-off payments’.
Unless you have a P45 from a previous source of income or employment that you received in the tax year in which you received the pension payment, then the pension company needs to use an ‘Emergency’ tax code. This means that they have to assume that the amount of your withdrawal will be received for every month of the tax year. As a result, the rate deducted could easily be at 40% or even 45%, even if the amount of tax you should actually pay may well only be 20%.
You can of course claim back any excess tax, but how and when you do this will depend on the circumstances. In some cases you will have to wait until the end of the tax year and use the self-assessment system.
Finally, it’s worth noting that once you have taken more than just the 25% tax free cash from your pension fund you will need to tell the providers of any other pension funds to which you are contributing, as your annual tax efficient contribution allowance will then fall from £40,000 to £10,000.