The key issue at the heart of Pension Freedoms is that over 55s now have more or less unfettered access to their pension pots. This was achieved by abolishing the limits on how much can be withdrawn from your pension and by removing the requirement to purchase an annuity should you be fortunate enough to live to your 75th birthday.
So just because you can withdraw your whole pension on your 55th birthday, should you?
What perhaps isn’t stressed enough is that beyond the first 25%, everything you withdraw from your pension is taxable income.
Even if you have no other income at all in a given tax year, withdrawing £150,000 from your pension would generate a tax bill of £36,200, meaning that you would only receive £113,800 (see workings below).
Withdraw £150,000 less 25% Tax free Cash of £37,500: Total Taxable: £112,500
Personal Allowance (2017/18): £11,500 tax at 0%
Next £33,500 taxed at 20%
Remaining £67,500 taxed at 40%
Personal allowance withdrawn (£1 for every £2 above £100,000) £112,500 – £100,000 = £12,500. £12,500 divided by 2 (£1 for every £2 of income)
This is effectively taxed at 40%
Total tax payable on £150,000 withdrawal = £36,200
A slightly less mad, but still unwise strategy
If you were really intent on withdrawing £150,000 from your pension, a better way would be to take your 25% tax free cash (£37,500) plus £11,500 (your annual income tax allowance) in year one, making a total of £49,000. Thereafter you withdraw £11,500 a year until the money runs out. At which point you would have nothing left to live on, but you would have paid zero tax.
Of course this assumes you have no other income, in which case it would be most unwise to draw on your pension pot so heavily.
It’s even worse if you are still working and already paying higher rate tax
However, if you were perhaps still working at 55 and were a higher rate (40%) taxpayer and wanted to tap your pension to invest in a buy to let property, your tax bill would be much higher.
Say your earned income was £60,000, you would pay an eye-watering £60,000 in tax on the £150,000 you were withdrawing from your pension, leaving you with just £90,000.
That’s not all though. Because your income for the year would now be above £123,000, you would lose your entire personal income tax allowance. This is because the allowance is withdrawn at the rate of £1 for every £2 you earn above £100,000. The cost in additional tax paid from losing this allowance would be £4,600 on your basic salary of £60,000.
Thus withdrawing £150,000 from your pension in one go as a higher rate tax payer would generate a tax bill of £64,600, leaving you with just £85,400 of your £150,000.
Still Pensions Freedoms aren’t all bad news. There are some powerful advantages for those wishing to leave a little something to their loved ones, which we’ll cover in Part II.
Take care out there