Understand The Tax Position Before Cashing In A Pension

,

With the new pension freedoms (effective April 2015) cashing in a pension can appear attractive but there is evidence many do not fully understand the pension tax rules and their implications.

Any money withdrawn from a pension is considered as taxable income on top of any income earned in a tax year. It is, therefore, possible a pension withdrawal could push an individual into a higher income tax bracket resulting in a significantly higher tax bill than may have been expected.

Currently, tax is payable on any income above £10,600. Beyond the tax free allowance up to an annual income of £31,785 basic rate tax of 20% applies. Any income above the £31,785 (up to £150,000) is then taxed at 40% with a higher rate at 45% above £150,000. An example may illustrate the issue.

Fred is 56 he is currently a member of a Final Salary Pension Scheme and is currently paid £25,000 per annum. He also has a personal pension scheme with a fund value of £80,000.

He has decided to cash in his personal pension in full to pay for his daughter’s wedding, to pay off credit card debts and have an extended holiday. From the £80,000 25% will be tax free leaving £60,000 as a taxable sum. Fred now has a total taxable income of £85,000 so he will effectively pay £22,643 tax on his pension fund withdrawal.

Fred is advised to transfer his personal pension fund to a SIPP (self invested personal pension). He withdraws 25% (£20,000) tax free to pay for his daughter’s wedding and leaves the balance invested in the SIPP. The value of the SIPP may continue to grow (or fall!) and Fred draws £10,000 from the SIPP 12 months after it is set up and for five more years thereafter. As a result, Fred pays a total of £15858 tax on the value of his pension fund a saving of almost £7,000.

It is important to remember if you are taking the state pension this is counted as income. The above example illustrates the tax savings that may be made on a relatively small pension fund value. For higher value pension funds the majority may be taxed at 40% or 45% resulting in a significant tax bill. Tax planning is therefore essential when considering cashing in a pension.

It is also essential to remember the opportunity only exists to cash in a pension fund once an individual reaches 55 years of age (unless there are exceptional circumstances). HMRC applies a 55% tax rate on what it considers as “unauthorised payments”. These include any payments before reaching 55 years old.

Should you want to discuss your options surrounding cashing in a pension once you have reached 55 years old then please do not hesitate to get in touch on 0800 043 8341 for a no obligation initial discussion or Email enquiries@thepensionreviewservice.com. We are FCA authorised and regulated and operate UK wide. Alternatively, complete the form below and we will call you.

The information in this article does not constitute financial or other professional advice.

RELATED POSTS

Frozen pension scheme – What are the options?

Moving An Under Performing Frozen Pension Plan To A SIPP