The financial impact of the lockdown may result in short term financial hardship and longer-term uncertainty for some. Hardest hit are those whose income has ceased or reduced. For those aged over 55 accessing pension funds earlier than planned is one option. Here we examine the pros and cons of doing so.
Taking money out of a pension fund may seem an easy way to fill the income gap. However, for many people it should be their last resort. The longer-term consequences of drawing a pension early may mean less retirement income in future, due to the loss of future tax-exempt growth on the money withdrawn. Some of the withdrawal may be taxable. It may also lead to the loss of tax relief on future pension savings and preclude eligibility for some means tested benefits. If pension withdrawals are the only means available for short term cash needs, then navigating these hurdles with financial advice can help to overcome these disadvantages.
While the first 25% of a pension pot can usually be paid out tax free, any withdrawal in excess of this is subject to income tax. Income withdrawals are added to other income received in the tax year and taxed at the appropriate rate. Larger sums withdrawn in one go can create a tax liability much greater than the usual rate of tax paid. Just taking the sums needed immediately will help reduce the tax burden.
HMRC require the pension provider to tax the withdrawal at source and as though the first payment is one of a monthly series. This can result in over taxation of the payment; a refund can be claimed by completing an HMRC form, which will be quicker than awaiting your 2020-21 self -assessment return.
The income tax payable on a pension withdrawal can be minimised with careful planning, for example, restricting the withdrawal to the 25% which is tax free. However, if this means taking out more from the pension than is required for immediate needs, it may unnecessarily reduce the funds available for later life.
Alternatively, taking part of each payment as 25% tax free and 75% taxable will reduce the amount required to be withdrawn to meet current income needs and preserve some of the tax-free element to be drawn later during retirement. This however will restrict the tax relief available on pension savings and so may only be a suitable approach if pension savings are not expected to be made in the future.
Rebuilding Pension Savings
You may intend to rebuild your pension once normal working resumes. However, this may not be possible due to a little-known restriction called the Money Purchase Pension Allowance (MPAA). Withdrawing even £1 in excess of the tax- free lump sum triggers a reduction in the annual amount you can save in pensions with tax relief to no more than £4,000 per year, including any employer contributions. A massive reduction from the £40,000 standard annual allowance for pension savings. This makes it difficult for “pension dippers” to restore the value of their savings once cash flow improves.
Due to the Coronavirus outbreak impact on earnings, many more individuals are likely to be eligible for Universal Credit of up to £594 per month. Drawing funds out of a pension means that the cash withdrawn counts as savings in the assessment of eligibility for means tested benefits. Money left invested in a pension scheme is not counted in the means test, unless the individual is over state pension age. Taking money out of a pension will reduce the help you could get from the State.
Future Income Needs
Withdrawing money from a pension fund early will reduce the pension available during retirement and especially so, if withdrawals are made from a fund which has seen recent falls in value. If there is no alternative to accessing a pension, then taking out as little as possible to just meet immediate income needs is advisable. It would also be opportune to review your ongoing investment strategy to preserve the remaining fund for your later life needs.
The lockdown will last for weeks and while short term financial pain is unwelcome, your pension fund needs to provide for decades of retirement income. For all these reasons your pension should be one of the last assets to be accessed and other alternative sources of income should be explored first.
LEBC has created strategies for clients undergoing financial difficulties due to the lockdown and your usual adviser will be able to offer personalised advice on how you might best meet the challenges.
Director of Public Policy
Please remember, no news or research item is a recommendation or advice to buy. LEBC Group Ltd is not responsible for accuracy and may not share the author’s views. The contents of this blog are for information purposes only and do not constitute individual advice. All information is based on our current understanding of taxation legislation and regulations. The Financial Conduct Authority does not regulate estate planning, tax advice, wills or trusts.Back to News & Views
Please click below to download a PDF version of this article.Download