Join our community of smart investors

Pension freedoms 2015: Your safety checklist

New pension rules are coming in April next year which will allow you to take more control over how you spend your retirement fund. But don't let the changes catch you out
September 18, 2014

For anyone close to retirement age these are confusing times. With what feels like a new pensions rule being unveiled every week, making financial decisions with confidence is tough.

The pension changes in the Budget will mean retirees have more choice over what to do with their retirement fund than ever before. However, having more choice increases the number of mistakes that people are likely to make. Here are some of the most important rules you need to remember if you are DIY-ing your retirement fund.

Don't mis-manage the method of lifetime allowance tax payments

The lifetime allowance (LTA) is the maximum you can build up in a pension fund without incurring a higher tax charge. The LTA is now £1.25m (from 5 April 2014), although people may have opted for a higher LTA in previous years. If you go over the limit, it is important to think about when you take your pension as it can have a big impact on your tax bill.

The charge on any excess pension over the LTA is as follows:

■ a lump sum is taxed at 55 per cent;

■ pension income is taxed at 25 per cent on top of income tax.

Alan Higham, retirement director at Fidelity, said: "This means if you are a 40 per cent taxpayer, the additional income tax will be the same whether you take your pension as a lump sum or income. Someone who pays basic rate tax will pay only 40 per cent income tax in total if they take their pension as income, while a 45 per cent income taxpayer will pay 58.75 per cent. If you know you are going to have to pay a LTA tax charge, then managing the method will have a positive impact on your tax bill."

Do take control of the lifetime allowance tax assessment timetable

Many people do not realise that a tax charge is only triggered once their lifetime allowance is exhausted. You will be assessed every time you commence taking benefit from a pension fund, or at age 75 if you have not taken any benefits, or when you transfer out of the UK pension system. When you take benefits from income drawdown, there is a second assessment at age 75 or before you buy an annuity.

However, the tax charge is only triggered once an assessment occurs when you have exhausted your LTA. You therefore have considerable control over when you will pay this tax. If you die before taking your pension, and have exceeded the LTA, your beneficiaries have to pay the tax.

Don't forget defined benefits pensions count towards your lifetime allowance

People with defined benefit pensions may not realise how this can impact on their LTA. To calculate how much of the LTA a defined benefit pension is worth, you take the annual pension amount at retirement and multiply by 20. The following factors have no impact on this valuation.

a) If the pension increases with inflation or not.

b) Whether you have a partner's pension as well.

c) What age the pension is taken at.

Mr Higham suggests: "One way to reduce the impact on your LTA is to consider taking early retirement, or sacrifice some of your pension to provide a higher income for a dependant, or for higher future pension increases for yourself.

"For example, if you have defined benefit pension income of £70,000 a year at age 65, that would be valued at £1.4m, meaning you'd have to pay a tax charge of £37,500. But if you asked for it to be paid five years' early, then it would typically reduce your income by 25 per cent to £52,500 a year which would only use £1.05m of your LTA."

Crossing higher rate tax threshold by cashing in pot

You will be charged higher rate (40 per cent) tax if you have more than £41,866 taxable income in a tax year. This could easily happen if you decide to cash in your lump sum without checking what impact that would have on the total potential earnings for that year. Mr Higham says: "While pension providers pay the basic rate tax on behalf of individual clients, you are responsible for completing a self-assessment form. Without taking this into consideration, you may get an unexpected (not to mention unpleasant) demand from the taxman."

Be careful calculating what counts as pension savings

Everything in your pension pot counts towards your lifetime allowance. This includes any workplace schemes which you may not pay into, but your employer does. It also includes overseas pension schemes that qualify for UK tax relief. Many people don't realise this, and they often lose track of the various pots they have accumulated. This can expose them inadvertently to paying more lifetime allowance tax than they need to.

Some people also have retirement savings in policies that aren't technically classed as pension schemes. If you aren't sure, call the company that's managing the money and ask if the money is held in a pension tax wrapper.

Know the cost of taking tax-free cash

Many people choose to take their tax-free cash as soon as they can at age 55, even though they are still working and aren't taking any pension income. But as we outlined in last week's IC, when you take your pension benefits, either as a lump sum or income drawdown, you effectively change the tax rules around your savings - particularly the death benefits.

If you die before age 75 having not taken any benefits then you can pass your pension fund on free of tax. After taking any benefits, your remaining savings taken as a lump sum will be taxed at 55 per cent, should you die. Or, an adult dependent can draw income and pay tax at their normal rate. Also, your tax-free lump sum will be in your estate for inheritance tax purposes which may mean it is taxed at 40 per cent. Remember - you will also be taxed on the income you take from your pension which means you could fall into the 40 per cent tax bracket for any year that your taxable income exceeds £41,866.

Taking tax-free cash does not allow you to top up your fund

You can continue to pay into your pension after taking tax-free cash but the lifetime allowance still applies. In other words, taking out tax-free cash does not mean you can top up the amount by the cash you have taken out. HM Treasury has also imposed strict rules around recycling tax free cash into a pension scheme.

Do check existing policies for guarantees

The thought of tax-free cash is extremely appealing, but if you have a guaranteed minimum payment in your policy this could be of more value to you that the total tax-free cash entitlement. You need to make sure you understand the value of the fund you are giving up before making a decision.