Pension freedom – Martin Lewis's five-minute briefing
What to do with pensions at retirement
The 6 April 2015 Budget saw the most radical changes to private pensions for a generation. The political spin is it was for 'freedom and choice in pensions'. This sounds like an unmitigated plus. Indeed there are many more options, and for those who know what they're doing it's great, but it also means it's easier to make a mistake.
If you're about to take your pension, our free 40-page 'What to do with your pension at retirement' booklet has detailed help. Yet if you just want to be up to date with what pension freedom means, here's my five minute briefing to take you through it.
Pension freedom sounds like something from Braveheart – what's actually happening?
I suspect George Osborne does picture himself as a financial freedom fighter. Yet only time will tell whether these reforms will paint him as the man who liberated older savers or who exposed them to huge risk.
This is all about how you use your pension savings. As always you can take a quarter of it as a tax-free lump sum.
Yet for decades most people have effectively needed to use the remainder of the money to buy an annuity – a product that pays you an income each year until you die.
The Government announced pension freedom in the 2014 Budget to start in the 2015/16 tax year. It means anyone aged 55 and over can take the whole amount as a lump sum, paying no tax on the first 25% and the rest taxed as if it were a salary at their income tax rate.
Does it apply to all types of pension?
No, we're only really talking private pensions where you and/or your employer saved up a pot of cash for retirement. Technically these are known as 'defined contribution' or 'money purchase' pensions.
It doesn't apply to the state pension (see state pension boosting for more on that). Nor in the main part does it apply to pensions where what you're paid is a proportion of your final salary – known technically as 'defined benefit' pensions.
There are ways to convert these final salary pensions into a pot of cash, but for most that's best avoided, certainly without genuine independent financial advice (see below) and be very careful of scammers cold calling offering to do this.
Can anyone take cash out of their pension?
No, you can only take cash out once you're 55. If someone is promising to do it for you early, beware they could be a pension liberation scammer.
Is it worth taking out my pot as soon as I can?
Generally not. If you're in your 50s or early 60s you're probably still working towards retirement and should often be focusing on putting yourself in a position to have enough income when you do retire. Keeping the money in your pension hopefully enables it to grow.
Plus by accessing your funds earlier than needed you can reduce your ability to make future contributions.
Yet you're saying if I want to, I can just take out all the cash?
If you choose to yes, but remember only 25% of it is tax-free. The rest is taxed at your current income tax rate.
So when they're ready to retire most people will be aiming not to withdraw too much in a year, so it pushes them up a tax bracket.
For example, you can earn up to £43,000 a year (2016/17) before you pay the higher 40% rate of tax. So if you earned £30,000 then took a taxable £10,000 out of your pension it'd still be at the 20% basic-rate. If you took £15,000 out, £13,000 would be at the 20% rate, the rest at the 40%.
OK so if I don't want to take it all out what can I do?
This will be the most common scenario for most people – and there are quite a few options, some of them can be combined.
Option 1: Leave it invested in your pension for when you need it. Do this and it's important to understand when you withdraw cash you get 25% of each lump sum you withdraw tax-free. For example, if you had £100,000 and took £20,000 out you'd get £5,000 of it tax-free, the rest would be taxed at your current rate.
Option 2: Take 25% tax-free, then buy a flexible income drawdown product. This is a product you buy that keeps the rest invested so it can still hopefully grow, but you can also use it to take income when needed.
The tax here is different, you get the first 25% you withdraw tax-free and then the rest is taxed when you take it – which could be useful if you're likely to be in a lower-tax bracket once you're older.
Option 3: Take 25% tax-free, then buy an annuity. This gives you a guaranteed income each year for the rest of your life.
There are different charges on all of these, and it's important to check them out and always compare different providers.
It is also worth noting that if you take a big chunk out in a month, you may be charged emergency tax on it, as you will be taxed as though you are withdrawing that same amount each month. You can either claim it back with a P50Z or P53, or it will get settled at the end of the tax year.
Hold on, did you just suggest annuities, aren't they as dead as a dodo's granny?
Annuities are actually a decent concept. It means you get the security of knowing exactly how much you can spend each year, and that it'll last for the rest of your life. Yet there are three main reasons for their bad rep…
a) In recent years annuity rates have been crap – so people trading in £100,000 of their pension money may have got as little as £5,500 a year.
b) Instead of shopping around to home in on the best rate, most people just went with the firm they saved with - locking in at a far lower rate than needed, so they lost out every year for the rest of their lives. This is especially important if you have health issues where you could've got an enhanced deal.
c) With simple annuities when you die they just stop, so if you died after a year or so, they were very bad value and your inheritors got nothing.
Yet a good annuity at the best rate can still be valuable income security – a definite income for life – so for some it may be worth using for a chunk of your savings.
How much cash should I take out each year?
That depends on when you'll die.
OK, smart arse, am I meant to be a psychic now, when will I die?
Actually there are stats that answer this to a degree depending on where you live, current age, fitness and whether you smoke. They're shown in the Office of National Statistics life expectancy calculator.
These aren't easy to decipher, so we're soon launching a 'When Will I Die' calculator. In a nutshell though, the typical life span for a man who hits 65 in the UK is another 18 years, a woman 21. Add a little on that for safety and it means unless you've bad health you probably want to spend around 4-5% of what you've got a year.
Will taking cash out affect my benefits?
If you get a means-tested benefit like jobseeker's allowance or pension credit, then pension income can reduce that.
If you get a lump sum, then this may count towards your savings total – if you've over £6,000 of savings it can reduce your benefit, and over £16,000 it can stop it.
In fact once you reach state pension age, ie, roughly 63 for women and 65 for men, you may lose some benefits even if you don't take your pension because it counts as 'notional income'. For more help on pensions and benefits speak to Citizens Advice and use the 10-minute benefits checkup.
OK so it's not that simple, but you mentioned 'huge risk' at the start, let me guess you're going to warn me not to buy a Ferrari with the cash now?
I don't think I need to. If you choose to do that you know you're probably either rather rich already, know you're being foolish, or that you ain't got long left. Actually, I have two far more serious concerns.
The first is the opposite of the much-publicised Ferrari one. I'm concerned many will be nervous about releasing the cash in case they're left with none in old age and will therefore sit on it, never spending it, depriving themselves of the benefit and living a worse life than necessary.
Yet there's another one too. There are a lot of scammers out there cold calling and trying to get people to do all types of unsuitable things, such as release their cash before age 55 (often illegal, if not massively expensive), or cash in final salary pensions when they shouldn't, or a variety of other creative but dangerous causes.
OK it's complex, but hasn't the Government set up a free advice service?
No. It's set up a free guidance service called Pensionwise. This isn't just a semantic difference – this system will tell you what you can do, not what you should do. It won't include help on your benefits, nor on what product to get.
If you've a sizable pension pot it's worth spending the £300 to £1,000 it'll cost to get an independent financial adviser who can tell you what to do (get quotes from a few first). You can find a local one through VouchedFor or Unbiased – read more info on that in our Independent Financial Advice guide.
Our free detailed pension booklet on how to take your pension is available now and our booklet to saving into your pension is coming soon, a reminders will go in the free weekly email.
Right I'm with all this, but I'm years away from it, aren't pensions just crap anyway?
No. Though even if they were, that wouldn't change the fact that this new rule is to help those who have already saved.
The key benefit of a pension is most people can effectively save in it from their pre-tax income. In other words, for a basic-rate taxpayer to save £1,000 only costs them £700-£800 (depending whether they get the national insurance gain too).
People often unfairly berate pensions due to poor returns. Yet a pension is just a tax wrapper – a bit like the cling film you can put around a sandwich to protect it… in this case from the taxman.
You can put lots of different types of investment in it – from individual shares to cash. Many people in the 80s and 90s were (mis)advised to invest in 'with-profits' funds, which are like mortgage endowments and they've been crap.
Blaming the pension wrapper is a bit like blaming the cling film because the dodgy meat you put in it is dodgy.
What about people who have already retired, can they cash in their annuities?
No – you can't cash in your annuity at the moment. But the Government has said that people will be able to do so from April 2017, so we'll update this guide when more details are available.
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