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Any money withdrawn from a pension is considered as taxable income on top of any income earned in a tax year.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 email@example.com. We are FCA authorised and regulated and operate UK wide. Alternatively, complete the form below and we will call you.