From April 2015, new rules will give you almost unrestricted access to your pension pots. Here's how to cut your tax bill when you take out pension cash.
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Pension freedom: what's changing?
From 6th April 2015, Britain is set to undergo what some experts have described as a 'pensions revolution'. This is because radical new rules come into effect from the 2015/16 tax year, giving you almost unlimited freedom, flexibility and access when it comes to drawing down your pensions.
Then again, freedom always comes at a price. In this case, the price is that you largely take control of how and when you dip into your pension pots. But the downside of this new-found responsibility is you could end up with a hefty tax bill and a tiny pension income if you dig too deep, too soon.
You will be able to make almost unlimited withdrawals from your pensions on the following terms.
When you reach the age of 55, you will be able to withdraw cash from your pension pots as and when you decide. You will have unlimited access only to your money purchase (also known as defined contribution) schemes, such as personal pensions and workplace pensions, whose payouts are not linked to your salary and length of service.
This total freedom of access does not apply to final salary schemes, also known as defined benefit schemes.
And if you try to take out cash from your pension before reaching 55, then a minimum tax rate of a punitive 55% applies, so don't do it.
In effect, these new rules deliver massive freedom to pension investors. Indeed, on reaching 55, you could choose to withdraw your entire pension pot as a single lump sum – but this might land you with a whopping tax bill. Likewise, you could use your pension pot almost as a current account, dipping into it to withdraw cash as and when your lifestyle demands it.
Despite these restrictions, this new set of rules mean that, in time, almost every British worker will be trusted with unrestrained access to their pension cash. Of course, the danger is that the reckless or careless may plunder their pensions too deeply, leaving them with insufficient income in retirement.
So how can you take full advantage of the sums currently locked up in your pension without landing yourself with an enormous tax bill?
As the rules currently stand (and they could well change in future), you can use these five tips to pull cash out of your pension without being hammered by the taxman.
Don't take it all at once (stage your withdrawals)
In theory, once you hit 55, you could withdraw all of your (money purchase) pension pots as a single lump sum, and then hit the beaches in Brazil. However, this is likely to be the worst route to take, because you could face an enormous tax bill from non-tax-free withdrawals that are taxed as income.
Taking out such a large sum could push your total income into a higher tax bracket, leaving you paying higher-rate tax at 40% or even additional-rate tax at 45% on some or all of your pension cash. That's because non-tax-free pension withdrawals are taxed as income at your highest marginal rate of tax. In short, tread carefully, especially in the early days.
Take advantage of 25% tax-free cash
Current pension rules allow you to take up to a quarter (25%) of your pension pots as tax-free cash. This concession will continue after April 2015 and applies to multiple withdrawals up to this over 25% limit. Make the most of this allowance, as you won't be liable for any tax until your total withdrawals exceed this 25% ceiling.
Use 'trivial commutation' to cash in small pots
If you are aged at least 60, you could withdraw smaller pension pots as lump sums. If you have a total of up to £30,000 in one or more pensions, you can take this whole amount as a lump sum, which is called 'trivial commutation'. Also, you can take up to three personal or stakeholder pensions of less than £10,000 as cash payments, no matter how much you get from other pensions.
These more flexible rules (including increasing this limit from £18,000) were introduced in Chancellor George Osborne's last Budget and took effect from 27th March this year, so they are already being used to cash in small pension pots with no tax to pay.
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Make use of your personal tax allowance
If you are no longer working, or have a low income, then you can use part or all of your personal tax allowance (£10,000 for the 2014/15 tax year, £10,500 from next) to reduce your tax bill when withdrawing cash from your pension pots. Therefore, instead of taking out one lump sum in a single tax year, you could spread it over two or more tax years, therefore reducing your overall tax bill by spreading out your income.
Even if you use up your tax-free allowance, it's worth planning your withdrawals so that they don't push your total income into a higher tax bracket. Why pay 40% tax on pension withdrawals when, by careful planning, you can keep your highest tax rate at the usual 20%?
Lower your taxable income
When calculating the tax owed on non-tax-free pension withdrawals, HM Revenue & Customs add these cash sums to your other earned and unearned income (including State Pension payments). Therefore you can lower your tax bill on pension cash-outs by lowering your other sources of income. There are many, many legal ways to reduce your taxable income, such as:
- using tax-free ISAs (Individual Savings Accounts) to shelter savings interest and investment income and gains from tax. In the 2014/15 tax year, this ISA limit is a generous £15,000 per adult;
- transferring income-generating assets to your spouse in order to reduce your taxable income and make use of his/her personal allowance and other tax breaks;
- paying for childcare costs using childcare vouchers from your employer. Two working parents taking the maximum yearly vouchers can reduce their combined taxable income by nearly £6,000 a year;
- raising your pension contributions from their current level. However, there are likely to be 'anti-avoidance' rules in the pipeline to stop workers paying into a pension and then immediately withdrawing 25% of this sum as tax-free cash and the remainder as taxable income.
The golden rule
In summary, the golden rule for dipping into your pension pots for cash is "Don't take too much, too soon". Otherwise, you could end up broke after paying a large tax bill.
Many thanks to Laith Khalaf of Hargreaves Lansdown for his help with this guide
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