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Pension Changes | What It Could Mean For You

by The Bankruptcy Service

Posted on November 05, 2015 at 1:00 PM

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On 6 April 2015 the pension revolution began. The government introduced changes that allow anyone over 55 the opportunity to do what they want with their pension savings.

For the first time, money can be taken out of pension pots ahead of retirement. This is not necessarily a good thing however, if not used wisely.

So, the new regulations present the following options to those approaching retirement:

  1. Take all the pension pot in one go.
  2. Take it in instalments.
  3. Put it into an annuity.

These are not either/or options – you can mix and match.

The changes affect those who have a “defined contribution” or “DC” pension, and most personal pensions fall into this category. With this type of pension, the amount you end up with once retired depends on the performance of certain investments which savings were put into. As for final salary or “defined benefits” pensions, which are quite commonplace in the public sector, the new rules will not affect such schemes.

Taking It All

So at the age of 55, you are free to cash in your pension fund, but there’s a big problem – tax. If you take out a large amount of money, then that money will be taxed, as it will count as income for that year. The first 25% won’t be affected, but after that you could be in danger of hitting the high tax brackets. After all, the government expects to rake in £4 billion pounds over the next five years from taxing those who cash in on pensions.
Let’s look at an example. Mr Smith has saved £100,000 in his pension pot over his working life, and is looking to cash in what he has. Mr Smith also qualifies for a full state pension. So Mr Smith takes his £100,000 out and takes the first £25,000 tax-free as per the regulations. However, the remaining £75,000 is now taxable. If Mr Smith’s state pension for the year amounts to £6,029.40, so that means he has earnings for that year of £81,029.40. This would see his earnings attract a 40% tax rate, so he would lose £21,815 to the taxman. So from that £100,000 he cashed out, he will only see £78,185.
And the higher the savings, the more the taxman will seize, and thus the more you would lose from your pot. It is estimated that a £280,000 fund will lose over £80,000 to tax.

Taking it in instalments

This will be the best option for many, as it limits the amount the taxman gets, by staggering payments across different tax years. It will especially suit those looking to cash in large amounts. It is referred to as “drawdown”, as savers remove the right amount of money periodically to remain below the 40% tax bracket. To use another example, if a person with £280,000 to cash out draws out £42,000 a year for five years, they will end up paying just £31,400 in tax, which is less than half what they would have paid if they had withdrawn all the money at once (just over £80,000).

One down side is that you don’t get the 25% tax-free lump sum all in one go, but in dribs and drabs instead.

Putting it into an annuity

An annuity is a regular income, paid annually until you die, at which point the income dies with you. Your money is entrusted to an insurance company, who will pay you a fixed income. So if you have £100,000 in your pension pot and take the £25,000 lump-free sum, the remaining £75,000 could be swapped for an annuity of, let’s say, £5,000 a year. This amount will be lower if you want some income for your partner, but higher if you’re in poor health and/or a smoker.

A cautionary note

Whilst these options sound great, not all pension companies will allow you full flexibility to do as you please, and you may be required to swap providers.

What To Do With The Money

Basically – anything. If you withdraw money, then it is yours to do with it as you see fit – buy a sports car, a castle, or invest. That is your choice. Thankfully, early indications of those that have utilised the pension reforms in its early months seem to be acting sensibly on the whole, and there is a trend to investing the money rather than spending wildly.
Surveys have indicated that over a third of people over the age of 55 have indicated they intend to take money out of their retirement pot over the next year.
A poll of 11,000 people by financial firm Hargreaves Lansdown undertaken in early May 2015 found that materialistic purchases were being shunned in favour of more sensible investment decisions. About a quarter said they intended to reinvest money in an ISA, whilst almost a third would use it for general living expenses. Just under 20% would use money for a holiday, while only 7% intended to invest in a buy-to-let property. It seems annuities are no longer a popular choice for retirees investing money either, with under 10% intending to take that route.
Another factor is that in September 2014 the chancellor George Osborne announced that he was abolishing the “death tax”, the 55% charge payable on an inherited pension pot. This has made it a more appealing option to keep money in a pension fund.

So here are some more options:
Leave it in a bank: Interest rates are low, so there isn’t much to be made in savings compared to past years, but new rules are on the way in April 2016, that means income will largely be tax-free, and by shifting it progressively into cash ISAs, the money can become entirely tax-free so that it is only earning you money. You also have the advantage of being able to access it at any point, so it is not tied up and difficult to get to.
Leave it in the hands of an investment manager: There is a general rule or guide from financial experts that it is safe to take an income of about 4% a year without damaging capital in the medium term. The preferred way to do this is by investing in a mix of corporate bonds that pay fixed rates of interest, and companies that pay out dividends. A fund of £75,000 could theoretically pay out around £3,000 a year, but the return is not guaranteed and comes with its own risks, as stocks can go up and down in price. However, you can transfer the money into stocks and shares ISAs, for an amount up to £15,000 per year, which means you can progressively shelter it from tax.
Invest in property: A £75,000 fund could in theory be used as a deposit on a buy-to-let property – for example a 30% deposit on a £250,000 property. It is entirely plausible that a property could be bought that brought in a good £500+ profit each month, when deducting the mortgage payment from rent, but it is important to consider the other fees associated with buying property, such as account letting fees, maintenance and so on – and the income will be taxable.

But the real beneficiary may well be, not surprisingly, the government. It was originally thought that the pension reforms could net the government four billion pounds over the next five years from axing the money released from pension pots. However a report in the Telegraph recently suggests that the government has underestimated revenue, with 1.2 billion pounds expected to be earned in the first year, well ahead of expectations.

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