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Ten pitfalls to watch out for if you’re tempted to withdraw money from your pension


Pension freedoms: Over-55s can make withdrawals from retirement savings whenever they wish

Older people are being urged to ‘stop and think’ before starting or bumping up pension withdrawals to make ends meet.

Soaring household bills are expected to push many over-55s into tapping their retirement fund earlier or taking out bigger sums than planned, but doing so involves significant risks.

Potential pitfalls include forking out too much tax, limiting your ability to pay into your pension in future, and even running your pot dry, warn experts.

One glaring red alert is that government forecasters have just sharply increased their estimate of the tax take from people making pension withdrawals in the year just ended, from £1.2billion to £1.7billion.

This sets expectations of a ‘new normal’ of pension dipping activity as people look to their retirement funds as a bank account to support their day-to-day living costs, says Andrew Tully, technical director at Canada Life.

‘This is understandable behaviour as people look to make ends meet but we need to remember that pensions are already likely to be stretched over a longer lifespan than previous generations and any withdrawals will need to be sustainable.’

Pension freedoms mean many older people now opt to keep their fund invested and draw down an income to cover spending, and if they are lucky splash out on enjoying their retirement too.

Meanwhile, some people have no choice and will have to step up withdrawals to pay essential bills. In all cases, you are more likely do this safely if you know about the traps in advance.

>>>Read our 12-step guide to living off your pension investments here. 

Withdrawal trends: The number of individuals taking flexible payments from pensions and their value (Source: HMRC and AJ Bell)

Withdrawal trends: The number of individuals taking flexible payments from pensions and their value (Source: HMRC and AJ Bell)

In normal times – the pandemic outbreak side – the start of the new tax year is peak pension withdrawal season, with hundreds of thousands of savers dipping into their funds and many doing so for the first time, says AJ Bell’s head of retirement policy Tom Selby.

But he cautions: ‘This year is likely to see record numbers accessing their hard-earned pension pot.

‘Spiralling inflation is already hitting household budgets and as eye-watering gas bills land at millions of Britons’ doors, it is inevitable more people will turn to their pensions to ease the immediate financial pain.

‘Anyone thinking about accessing their pension for the first time or hiking withdrawals to cope with rising living costs should stop and think before making a rash decision.

‘Accessing your retirement pot early or withdrawing too much, too soon could have disastrous consequences over the long term.’

We explain 10 pitfalls to be aware of when tapping your pension investments below.

1. Running out of money

Not knowing when you will die is one of the great risks you take – up there with market crashes – when you rely on an invest-and-drawdown strategy in retirement.

Fewer people every year retire with final salary pensions, which provide a guaranteed income until you die. So unless you work in the public sector, for many people the state pension is the only income they will be able to depend on indefinitely.

‘Withdrawing too much, too soon from your fund means you’ll increase the risk of running out of money early – and potentially being left relying on the state pension,’ says Selby.

‘In 2022/23, the full flat-rate state pension will pay just £185.15 per week, a long way below the spending needs of most people.

‘Put simply, if you raid your pension pot early, you’ll either need to keep your withdrawals very low – potentially harming your quality of life later in retirement – or face up to the prospect of your pot running out sooner than planned.’

2. Risk of holding cash

If you do need to make pension withdrawals to cover important bills, ensure you don’t take too much and let it pile up in a current or savings account paying no or little interest.

Since the pension freedom reforms in 2015, research has shown many people have switched retirement savings into current accounts and let the money get gobbled up by low interest rates and inflation. 

Unless you need retirement money for living expenses or a specific spending purpose, moving it into cash is frowned upon by financial experts.

They warn your savings will just lose value – particularly at a time when inflation is running hot.

3. Losing future pension growth

Taking an income from your pension means you miss out on the potential for bigger returns from staying invested in a pension or drawdown scheme, and narrow your financial prospects down the line. 

‘The sustainability problems created by taking an income early from your pension will be compounded if you miss out on investment growth at the same time,’ says Selby.

‘While savers have total freedom over how to invest their retirement fund, it usually makes sense to take a bit less risk when you start taking an income from your pot.’ 

He adds: ‘A period of high inflation presents a major challenge to anyone drawing a retirement income.

‘Most people will want their pension withdrawals to increase in line with inflation in order to maintain their living standards. However, if inflation runs hot for an extended period of time, this will have a big impact on the sustainability of a withdrawal plan.’

‘It’s also worth taking a step back and thinking about your own personal inflation rate. Sit down, tot up your costs and income sources, and try to design a sustainable retirement income strategy that meets your needs.’

4. Pound cost ravaging

Older people relying on an income from investments in retirement need to be more vigilant than most, in case there is suddenly a need to adjust or even halt withdrawals and lean on other savings for a time.

This is to avoid a nasty trap known as ‘pound cost ravaging’ which can do severe damage to pension investments, especially in the early years of retirement.

It means that when markets fall you suffer the triple whammy of falling capital value of the fund, further depletion due to the income you are taking out, and a drop in future income.

This poses a problem every time markets take a tumble, but is especially dangerous at the start of retirement because investors can rack up big losses and never make them up again if they aren’t careful.

Read more here on how this works and find out the strategies to mitigate the dangers, especially if you have recently begun taking an income from your pension investments. 

5. Limiting future pension contributions

The standard amount you can put in your pension every year and qualify for tax relief – including your own and your employer’s contributions, and the tax relief itself – is £40,000.

The rules are more complicated for higher earners, whose annual allowance is ‘tapered’ down to either £10,000 or £4,000.

However, people who start tapping pots for any amount over and above their 25 per cent tax free lump sum are only able to put away £4,000 a year and still automatically qualify for tax relief from then onward.

This limit is known as the ‘money purchase annual allowance’. After it kicks in you risk a shock tax bill if you unwittingly pay in too much. Read more here. 

‘Once you take some taxable income from your pension, the MPAA restricts what you can save in future to £4,000 a year,’ says Andrew Tully of Canada Life. ‘Given the pandemic and current cost of living crisis the Government needs to remove this restriction.’

6. Emergency tax hassle

HMRC applies an emergency tax code to savers who make their first pension withdrawal, assuming they will take out a whole series of sums in that tax year even if they have no intention of doing so.

They are taxed as if they would take the same amount every month, so those taking only a one-off lump sum end up overpaying tax.

They then either have to reclaim the tax themselves or wait for HMRC to give it back. 

Tully says: ‘If it is your first withdrawal an emergency tax rate may be used which usually means that too much tax is deducted.

‘The excess can be reclaimed from HMRC but it can take a couple of months. If possible, it may be helpful to start with a small withdrawal to make sure your provider has the correct tax code then take a larger withdrawal a few weeks later.’

This is Money columnist Steve Webb, a partner at pension consultant LCP, replied to a reader question about this here and explained how to get your money back as soon as possible. 

7. Overpaying tax

You can take 25 per cent of your pension tax free, but after that be mindful of income tax when making withdrawals.

The personal allowance will remain at £12,570 in the 2022-23 tax year, and income tax kicks in above that threshold, depending on your individual circumstances. 

STEVE WEBB ANSWERS YOUR PENSION QUESTIONS

       

‘Normally 25 per cent of your pension withdrawal will be tax-free with the remainder subject to income tax.’ says Tully.

‘This means that large withdrawals could push you into a higher tax bracket. Phasing withdrawals over several tax years can help reduce the income tax you pay.’

8. Inheritance benefits diminished

We reveal the order to use savings in retirement to defend your cash from the taxman here.

As general guidance, financial experts say spend your pension pot last. 

This is because hoarding your retirement fund and spending other available cash and investments allows you to keep your money out of the taxman’s clutches if you are worried about your heirs being landed with a big inheritance tax bill.

But anyone who wants to minimise their annual income tax, or use up their capital gains tax allowance efficiently, might also benefit from running down assets held outside a pension first.

However, circumstances vary so consult a professional about your own situation. 

Selby says: ‘Since 2016, savers have been able to pass on leftover pensions tax-free if they die before age 75. Where the pension holder dies after age 75, the remaining funds will be taxed at their recipient’s marginal rate when they make a withdrawal.

‘For those who want to leave assets to loved ones, it therefore often makes sense to leave as much of your pension untouched as possible in order to minimise your tax bill.

‘This means when you come to flexibly access your pension for the first time, you should think not just of your retirement income strategy but also your inheritance tax plans. If you have money held in an Isa, for example, this will count towards your estate on death.

‘For those who want to pass their pension on to loved ones, it’s also important to ensure your nominated beneficiaries are up to date so the right people inherit your pot.’

9. Stay alert for fraud

‘Don’t forget about scams,’ says Tully. ‘If someone encourages you to withdraw money from your pension to invest elsewhere take great care, especially if they put time pressure on you.

‘If an opportunity appears too good to be true, it usually is.’

The Financial Conduct Authority’s register of authorised firms is here. 

10 Under 55? Don’t even attempt it

Unless you qualify on grounds of very serious ill health, the risk of being scammed if you try to make pension withdrawals before you are 55 is very great. 

Our pensions columnist Steve Webb answered a question on the dangers of accessing a pension before you are 55 – sometimes dubbed ‘pension liberation’ by scammers – here. He explained people’s alternative options here. 

We know of no legitimate company that will help you do this, via a loan or anything else – only scammers. And you can lose your entire pension pot, and face a tax charge of up to 55 per cent of the pot on top for taking money from your pension before you are 55. HMRC will pursue the tax charge even if the pension itself has already vanished in a scam. 

If you find or are approached by a company telling you that releasing or borrowing money from your pension before you’re 55 is a good idea, contact Action Fraud. 

If you are considering raiding a pension when you are younger because you owe money, contact a debt charity like StepChange, or consult Citizens Advice. 

It’s best to use a not-for-profit debt charity and not a commercial debt consolidation firm to help you. Take care when doing internet searches to ensure you contact the correct organisation.

TOP SIPPS FOR DIY PENSION INVESTORS

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