The pension changes have created a new era of freedom and choice for defined contribution (DC) pension savers. However with choice comes responsibility, and the real possibility of employees making some huge mistakes. WEALTH at work, a leading provider of financial education in the workplace, supported by guidance and advice, has highlighted some of the decisions people are making, which might not have been the best choice for them.
Things employees shouldn’t do with their pension
Cash is not king– Some people are taking cash out of their pension, not to spend it in retirement, but to put it into a bank account.
Carol believes that cash is safe and that cash is king. She withdrew £10,000 cash from her pension in April 2015, not to spend, but to keep in a bank account. After paying basic rate tax on the withdrawal[1] she was left with £8,500 which she invested in a deposit account earning 2% interest. Over time, even if interest rates are more than inflation, it would take a substantial time to recover the tax paid. However, if inflation is more than the rate of interest then Carol’s cash will lose yet more value.
If employees prefer to hold some cash, then they could consider switching part of their pension funds into cash, but still keep it in the pension wrapper so it keeps its tax free status. Then they can always switch the cash value to other investments in the future, and still benefit from the tax free growth and inheritance tax benefits of a pension.
Withdrawing to reinvest – Some people are taking money out of their pension and reinvesting it in shares.
Ian wants to buy a portfolio of shares, so he cashed in his pension to do this. Over the years the value of his shares has grown and he now is looking to sell. If the gain is more than the CGT allowance he will be subject to tax. He did not realise that he could have kept his money in his pension, and just change what it is invested in, meaning that any growth in value would continue to be tax free; and outside of his estate.
If employees want to invest in different equities then they should speak to their employer to find out what their options are. A regulated financial adviser can also help with decisions like this.
Withdrawing when other taxable assets available – Some people are taking income from their pension when they have other assets which aren’t growing tax free, and are liable for income tax and inheritance tax, which they could be using instead.
Paul has a range of pensions and investments. He has started to withdraw income from his DC pension, but doesn’t realise that he might be better off living off his other taxable assets like taxable deposits (cash) and dividends, whilst his DC pension continues to grow in its tax efficient wrapper until needed.
For many, retirement income is not just about pension savings but all assets, such as ISAs and shares. Employees need to understand that this new retirement world is about looking at all assets to provide a retirement income in a tax efficient way.
Don’t forget income tax – Employees who access their pension pot sometimes forget that income from pensions is subject to income tax.
Wendy earns £19,000 a year and pays tax at 20%. She decides to cash in her £10,000 pension pot, but hasn’t realised that only 25% of the pot is tax free. The rest, £7,500, is actually counted as income, increasing her income to £26,500, so 20% income tax is due. Instead of £10,000, she actually gets only £8,500 from her pension, as £1,500 is paid in tax.
When it comes to income taxes, many people think only of the money they earn in their payslip. It is important for employees to account for all taxable sources of income and this can include income from pensions, savings and investments.
Accidental high rate taxpayer – Some people are taking all the cash out of their pension in one go, and in some cases those that have never been a high rate tax payer, are suddenly finding themselves paying 40% tax.
Phil is earning £38,000 and normally pays income tax of 20%. He has a DC pot of £42,000 and decides he wants to cash it all in. 25% of it (£10,500) is tax free. However, tax is due on the remaining £31,500 and as this is added to his earnings, it takes him into the higher rate tax bracket of 40%. He will be taxed as if he has earned £69,500. £5,000 of the pension pot would be taxed at the 20% rate and a whopping £26,500 at the higher rate of 40%, making a tax payment of £11,600 on his pension.
It is important for employees to remember income tax when withdrawing money from a pension. Phil could have withdrawn his money over a number of years, keeping the withdrawals below the 40% bracket, and saved himself £5,300 in unnecessary tax. He could also look at ways of paying the lowest amount of possible tax by considering how he could utilise all his assets (pension and non-pension) to make the best use of all available tax allowances.
Jonathan Watts-Lay, Director, WEALTH at work, said: “Like any investment pensions are subject to market conditions, but the general rule is that if you don’t need your pension money now, keep it in its pension wrapper so it can continue to grow tax free and benefit from the inheritance tax protection. We are concerned that without the necessary financial education and advice too many mistakes are being made which have long term consequences. We urge employees who are considering withdrawing money from their pension to think about if they are making the best choices and to research what other options are available. Poor decisions which result in more tax being paid than is necessary ultimately means less money at retirement – clearly employees would not do this if they understood the implications. If they aren’t sure about the decisions they are facing then they may want to consider taking regulated advice.”
[1] 25% of withdrawal of £10000 is tax free, the balance is subject to 20% income tax. 20% * £7,500 = £1,500 tax. Net amount received is £10,000 – £1,500 = £8,500
