How To Take Money From A Pension

Now we have a reasonable idea of how much we can spend in retirement, the obvious follow question for any self respecting part-time finance blogger to ask is “how do we get our mitts on the cash?”.

Pensions are a bit complicated, there are certain elements and foibles I haven’t referred to below, but taking money from a pension is just one of those “higher risk” jobs. It can go wrong, and it can be expensive if it goes wrong.

As a consequence it is sensible to consult with a qualified financial adviser before doing so.

In 2014 George Osborne announced an overwhelming change to how we can all take money from our pensions. The old rules meant people could only either use their pension to buy an annuity, or draw from their pension over time but only at a rate prescribed by the government.

This instinctively just feels a bit unfair. If individuals were increasingly having to bear the risk of saving enough for their own retirements, rather than relying on nice, lovely final salary schemes - then why should an insurance company or the government determine how that same individual then spends the money?

Osborne took action to right this wrong, and despite initial concerns - not many encashed their pension overnight to buy a Lamborghini. Give folk a little responsibility, they might just surprise you.

Anyway, I digress. The point is that since 2015 when the relevant legislation was enacted, there are now more options available to all of us to fund our retirements.

The main ones are summarised below.

1. Encash the whole lot.

   
   

One, fairly nuclear option, is to encash your whole pension in one go.

If you do this, 25% of your pension value (up to a limit of £268,275 under current rules) will be tax-free. The rest will be added to your taxable income for the year and taxed at your marginal rate of Income Tax.

So, if I have a hypothetical client who has no other income and a pension of £400,000 in size, if she chooses to encash the whole lot in one go she will end up with a tax bill of £121,203. Sub-optimal.

Unless you have a “small pot” this is unlikely to be a sensible strategy.

2. Encash a smaller lump sum.

   
   

Working on the assumption that you don’t have a burning desire to pay a mega tax bill - you can choose to lift a portion of your pension as a smaller one off lump sum. Again 25% of this sum will be tax-free, the rest will be taxed as income.

So, sticking with our hypothetical client, if instead of lifting all of her pension in one go, she withdrew £67,026 from her pension instead - £16,756 would be tax free and £50,270 would be taxed.

I have picked this number specifically as it would allow our fictional client to take £67,026 out of her pension and still remain a Basic Rate Taxpayer. She would pay £7,540 in tax in this situation - an effective rate of 11.2%, compared to an effective tax rate of 30.3% if she lifted the whole lot.

Previous statement applies, under current rules you can only take up to 25% of the total value of your pension (or £268,275, whichever figure is lower) as a tax free withdrawal.

3. Withdraw tax free cash, and leave the “taxable bit” invested.

   
   

You can choose to take some or all of your available tax free cash lump sum, but leave the associated “taxable bit” in your pension. It is important to note than in 99% of cases, if you choose to do this the remaining “taxable bit” will be three times’ the size of the tax free withdrawal.

Again, an example. Our hypothetical client lifts £100,000 from her pension. The remaining £300,000 associated taxable portion remains in her pension, invested or whatever.

She can then subsequently choose to use this £300k portion to buy an annuity, or instead withdraw money from this pot as and when she chooses - recognising that each time she does so she will need to pay Income Tax at her marginal rate to access the funds.

It is important to be aware that whenever any of us lift money from our pensions which is taxable, an emergency tax code is applied by HMRC.

What happens here is they assume that whatever the amount you have withdrawn is, is the sum you will be taking each month from your pension moving forwards. And this means too much tax may well be deducted from this first withdrawal, and the sum landing in your bank account may well be too low.

If you get caught by this, reclaiming the tax from HMRC is not a difficult job. You can do this online, or access the form to post to them here.

Please don’t pay these mugs a fortune to do it for you.

There are more niche use cases out there depending on the individual but that it just about it.

If you’re not really a words person - then first of all what on earth are you still doing here, and second of all I’ve recorded a short summary video summarising these options for you.

The main questions to ask yourself before choosing how you want to take money from your pension are:

• How much flexibility do I want?

• How much money do I need, both now and in the future?

• How much tax am I comfortable paying?

• Do I still want to potentially contribute to a pension in future? If so, how much?

• How comfortable am I with investment risk?

• If I take a big lump sum, what will I actually do with it?

  
  

Answer all of these, and you will be in a good place to make an informed decision.

Have a great weekend.

None of the above is intended to constitute advice to any individual. If you have questions specific to your individual situation, please do contact a regulated financial adviser.