Many people need to draw an income from their pension investments to cover everyday bills.
Since the pension freedoms launched five years ago, April and May of the new tax year have consistently seen the greatest volume of withdrawals.
Cash taken out of UK pension pots is up to a third higher in the first 2 months of the new tax year than at other time of the year.
Generally, this will simply reflect people making the most of a fresh set of tax allowances.
Beware though, there are issues that you need to be aware of, both for those accessing your pension for the first time and those who have done it before – particularly when financial markets are seeing dramatic falls such as during the current pandemic.
Taking taxable income from your pension, which is anything above your 25% tax-free lump sum, will create an irreversible £36,000 cut in your annual allowance.
If you are considering taking taxable income from your retirement pot for the first time then you need to be aware of the impact it will have on your ability to save tax in your pension in the future.
Taking any amount of money however small of taxable income will activate the money purchase annual allowance (MPAA), reducing the amount you can save in a pension each year from £40,000 to £4,000.
If you activate the money purchase annual allowance (MPAA) you will lose the ability to carry forward unused pensions allowances from up to 3 previous tax years.
In some cases the impact will be a £156,000 reduction in the potential annual allowance in the current tax year, from £160,000 to £4,000.
To avoid an annual allowance cut, if you have an option you should consider using other money held in Isas or cash savings accounts first.
If you only have your pension, just taking your 25% tax-free cash will also allow you to retain the £40,000 annual allowance.
Your first taxable withdrawal will be subject to emergency taxation.
Since the pension freedoms launched in April 2015, well over £500million has been repaid to savers who were overtaxed on taxable withdrawals.
When you first take a flexible payment from your pension, HMRC will automatically tax it on an emergency basis.
Which means that the usual tax allowances are divided by 12 and then applied to that first withdrawal.
If someone made a £12,500 taxable withdrawal in 2020/21 and had no other taxable income, they might expect to be charged no income tax as the withdrawal is within their personal allowance.
However, because it is their first taxable withdrawal only £1,042 (£12,500 personal allowance divided by 12) is taxed at 0%.
The next £3,125 (£37,500 basic-rate tax band divided by 12) is taxed at 20%, with the remaining £8,333 taxed at 40%.
In total, rather than paying zero tax they would face an initial bill of £3,958.
Anyone still working will see any overpaid tax in the first month will be taken out via your tax code.
If you no longer work and it is a single payment over the tax year there are 2 options.
You can wait until the end of the tax year for HMRC to remedy it for you, or you fill out 1 of 3 forms.
If the withdrawal used up your entire pension pot and you have no other income in the tax year, use form P50Z
If the withdrawal used up your entire pension pot and you have other taxable income, use form P53Z
If the withdrawal didn’t use up your pension pot and you’re not taking regular payments, use form P55
Once you’ve filled out and sent off the relevant form, HMRC should refund your overpaid tax within 30 days.
Fluctuating pound sterling
Be careful of big income withdrawals during falling stock markets. We are currently experiencing big falls in stocks of more than 20%.
The Covid-19 pandemic and global economic shutdown means that you need to understand the importance of investment risks that you are taking and managing withdrawals sensibly.
Anyone taking a 5% inflation-adjusted income from their fund who took a 20% hit as a result of the Covid-19 outbreak in their 1st year of drawdown and a 4% growth thereafter could see their pot run out after 18 years – 3 years sooner than if they suffered the hit 10 years into retirement.
Remember, an average life expectancy at 65 is 18.6 years for men and 21 years for women, a man has a 1 in 4 chance of living another 27 years, while a woman has a 1 in 4 chance of living another 29 years.
Savers wanting to manage withdrawals and avoid selling down their capital at a low point in the market could try to other resources such as Isas, savings or your 25% tax-free cash – in order to keep your pension intact.
The rest of your pension
If you’re just taking your tax-free cash, you still have the remaining 75% of your fund.
The majority of savers believe accessing your 25% tax-free cash as the main reason for entering a pension income drawdown scheme.
However, accessing your tax-free cash won’t necessarily mean a change in your underlying investments, it is worth using this as an opportunity to review your retirement plans and ultimate goals.
Someone planning to take a regular income after accessing their tax-free cash will likely have a different asset allocation to someone who doesn’t plan to touch the remaining money for 15 years.
While many will concerned at the prospect of investing at the moment, it is worth remembering that short-term volatility has historically been the price you pay to enjoy longer-term growth.
Investors also need to be aware of the risks they are taking. Although investments can go down in value as well as up, the value of cash will be adjusted by inflation over time.
What happens when I die
Since 2016, savers have been able to pass on leftover UK pensions tax-free if they die before age 75.
When a UK pension holder dies after age 75, the remaining funds will be taxed at their recipient’s income tax rate when they make a withdrawal.
For those who want to leave assets, it therefore often makes sense to leave as much of your pension untouched as possible in order to minimise your tax bill.
Which means, you should think not just of your retirement income strategy but also your inheritance tax plans.