New figures from the Financial Conduct Authority (FCA), show that in the three months to September 2015, over 120,000 ‘cashed in’ their pension pot and withdrew every penny they had.
For some people this will have been the right thing to do, for others though, it may well have been a mistake, which could leave them unable to make ends meet in years to come.
So, if you are thinking of ‘cashing in’ your pension, what are the key things you need to know, and think about, to make sure you are not making a mistake.
#1: Are you old enough?
You can only get access to your pension if you are over 55.
Obviously just because you are 55 doesn’t mean that this it the right thing to do, but if are not at least this age you can’t even consider it.
One quick aside, if you are younger than 55 and are told by an adviser that you can access the pot, then tread very carefully. You are probably at risk of being conned out of your pension and could potentially end up losing your capital and being handed a tax bill by HMRC for the privilege.
#2: Can you afford to take money from your pension?
This is key, taking the money now might seem attractive, but will it leave you unable to pay the bills both now and in the future?
We would recommend some basic cashflow planning, looking at your outgoings now, projecting these forward, whilst taking account of inflation and adding in any lump sums of capital you will need to spend in the future.
Now deduct the State Pensions payable to you and your spouse, as well as any other sources of income, for example other pensions, investments or savings.
If you are left with a shortfall it is doubtful that you can afford to cash in your pension.
This cashflow planning can be complex and time consuming, but it is a vital task if you are to prove to yourself that you can afford to cash in your pension.
Many professional advisers, including those at Investment Sense, have sophisticated software to run these calculations, which will tell you whether or not you can afford to take large lump sums from your pension.
#3: What will you do with it?
There are often perfectly valid reasons for taking money from a pension, for example to repay debt, which will reduce your outgoings and make retirement affordable.
However, we are concerned that some people are taking money from their pension when it would be better not to.
For example, taking money from a pension to invest in an ISA just moves money from one tax-efficient savings option to another, and could mean you’re landed with a large income tax bill.
#4: Is there a better way?
Everyone has an objective they want to achieve when they take money from their pension. Before you go ahead, look at whether there is a better option.
For example, if you are withdrawing money to give to your children or grandchildren, could you take it from other savings or investments, which may not trigger an income tax charge when you take the money out?
#5: Do you need all the money?
We’ve heard of some people taking money out of their pension “just because they can” and “because they do not trust pensions”.
Many people are cynical about pensions, but taking money out of a tax-efficient environment and potentially paying income tax, for no good reason, seems to make little sense to us.
As a rule of thumb, only take as much as you absolutely need and even then make sure you can afford to do so and it won’t leave you short of cash in years to come.
#6: Are you giving up valuable guarantees?
The FCA figures showed that many people are giving up potentially valuable Guaranteed Annuity Rates (GARs) just to get their hands on a lump sum.
If you are taking money from your pension to provide an income, you are unlikely to match the return you get from a GAR, if indeed you have one.
If you are in need of a lump sum and planning to take it from a pension with a GAR, we would suggest you look very carefully at other options, so you can still benefit from your GAR.
In a nutshell, check carefully whether or not your pension has a GAR and if it does think long and hard before you give it up.
#7: Would a ‘mix and match’ solution be better?
Retirement planning doesn’t have to be an ‘either / or’ decision, with all your pension pot being used to give a lump sum or an income.
Indeed, many people have a need for both. For example, some capital to repay debt, improve the home or gift to younger generations, plus income to top up their State Pensions.
This is perfectly possible and with good advice it is often the case that you can meet your need for lump sums and income; it just takes careful planning and sometimes a small dose of realism!
#8: Advice or guidance to help avoid mistakes
We would say that wouldn’t we?
Of course we believe that high quality, independent, financial advice can add value to your retirement planning, while saving you from making mistakes.
The other option of course is to take guidance from Pension Wise, the organisation set up when the Government announced Pension Freedom.
To put it bluntly, you’ve probably never taken money from your pension before, it therefore makes sense to take advice / guidance to reduce the chance of you making a mistake and improve the likelihood of a good outcome.
#9: Reduce the tax
If you decide, or are advised, that taking a large lump sum from your pension is the right thing to do, you now must consider the tax implications.
You can withdraw up to 25% of your pension pot as a tax-free lump sum, the rest is added to your existing income in the tax-year the withdrawal is made and taxed at 20%, 40% or 45%.
Careful planning, for example making withdrawals in the tax-year after you have retired, when you are no longer working and will therefore have a lower income, could well significantly reduce the tax you pay.
#10: Go back to #1 and check again that you are making the right decision
We are concerned that too many people are making mistakes when taking money from their pension.
It’s always worth double checking that you have made the right decisions.
Thinking of taking money from your pension? We are here to help
If you are over 55 it can be extremely tempting to take money from your pension pot. However, the implications of withdrawing too much cash can be serious in years to come. Even if you are financially secure enough to do so, it’s important to plan the withdrawals carefully to keep the income tax payable to a minimum.
If you are thinking of taking money from your pension and would like advice, we are here to help.
Call Bev or Sarah on 0115 933 8433 or email firstname.lastname@example.org for help.