The new pension freedoms were launched in April 2015. It would be fair to say that these are a double-edged sword if used in wrong way.
Unfortunately, like a credit card, it depends who is in control. Just because you can, doesn’t mean you should! Used well, these can add real benefit, but used poorly and the consequences are well documented. It is the same with the new-found freedoms.
But pensions are not as easy to understand as credit cards.
Careful planning in conjunction with a financial planner can ensure that you make the most of these freedoms without falling foul of common mistakes. Poor planning can create irrevocable mistakes that could affect your financial future.
It’s also not just a simple case of ‘That’s how much I have, so that’s what I can spend,’ because if you make that choice, for many this will have repercussions and consequences that may not be anticipated or which materialise for many years.
The government may have us believing that a pension fund is a bank account. That is not our view. A pension is there to provide an income over the long-term, potentially spanning decades.
If I go into a supermarket and fill my entire trolley with cream cakes and alcohol and then go home and consume these, there is nothing anyone can do to stop me, provided I don’t cause an offence in doing so. However, objectively, this probably isn’t in my best interests in the short, medium or long term. It is the same with pensions. Essentially, provided the scheme allows it, you can do what you like, when you like. But that doesn’t mean it’s a good idea!
Pensions, if invested efficiently, can also potentially continue to grow in retirement. Pensions also have tax benefits which can continue both pre and post death, if understood correctly. Consequently, the failure to make use of other savings first which don’t have this potential, is common.
Drawing more money than is needed and adding these funds to an already low rate paying bank account, only to see the funds remain on deposit, is another common mistake.
We also mustn’t forget the timing of events.
So, ‘What?’, ‘When?’ and ‘How much?’ are critical to a sustainable lifestyle in retirement and beyond to your beneficiaries.
Here are some of key things to look out for:
Using Tax-Free Cash Before Other Savings
If you draw out your tax-free cash (now called a pension commencement lump sum) from your pension, it becomes part of your estate and doing so will also generally limit the ability for these funds to grow tax-efficiently in future.
General speaking, people should consider withdrawing from taxable savings first, then tax-free savings such as ISAs and then finally their pension. This will ensure they keep their pension, which is generally the most tax-efficient way of saving, sheltered from tax for as long as possible.
Drawing out More Than Is Needed
Pension laws do not require you to draw out all of your tax-free cash at once. If your pension scheme allows it, you can access only part of your tax-free cash and then keep the rest invested for later. This means that it can grow to more tax-free cash for the future.
Drawing Tax-Free Cash at The Wrong Time
Tempting isn’t it. Once you have identified a use for their tax-free cash, you may be keen to take it out. If you do that just after the investments in your pension have fallen in value, then you will be locking in that loss. Timing the market isn’t possible, but if there has been a big market fall, ask yourself honestly if you really need the money now, or can draw the funds from elsewhere, or whether you can afford to keep it invested for longer with a view to making up any losses when markets recover.
Drawing Tax-Free Cash and Doing Nothing With It
You may be considering accessing your tax-free cash for specific reasons such as paying off debt or to fund home improvements. However, it does appear that many people are drawing it out simply to save it elsewhere, often in a bank account.
This is not a good idea for several reasons. Firstly, because once it is in a bank account, any returns it earns could be subject to tax, whereas it would have grown tax-free in a pension and secondly, the bank deposit will be included in your estate for inheritance tax purposes whereas it is normally exempt from inheritance tax while in a pension.
Thirdly, having additional assets in a bank account may affect your ability to claim certain benefits whereas, if it is held in a pension, it is generally not considered.
So even if you then put the tax free-cash into other investments, you may find that you are only receiving the same returns which you were receiving in your pension fund, but now the money is subject to the problems listed above.
Drawing Tax-Free Cash When Not Paying Tax
Where your income means that you don’t use up your personal income tax allowance (currently £11,000 for the 2016/17 tax year), then it may not make sense to draw out taxfree cash. Instead, you may want to consider making a withdrawal from your pension plan, which is partly potentially-taxable.
The advantage of this is that you would then retain more tax-free cash in your pension, allow it to grow for the future.
However, accessing the income element of your pension fund will limit you to save a maximum of £10,000 into your pension in the future (in the current tax year and falling to £4,000 in the 2017/18 tax year).
Not Claiming The Full Tax-Free Amount
If someone has been in a pension scheme before 2006, then they may benefit from transitional protection within their pension scheme, often referred to as ‘protected tax-free cash’. The rules are quite complex and you should take advice, but this could mean that you are entitled to more than 25% of your pension as tax-free cash.
Choose carefully!
If you wish to take a step in the right direction with planning your finances, please feel to call us on 01626 833225 or email us to find out more or to arrange an initial complimentary meeting.
Important Information
Please note that the above article does not constitute financial advice.
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