It is now possible to withdraw any amount of money from your pension after you reach age 55. This has been dubbed ‘pension freedom’. Previously most people were forced to buy an annuity with at least 75% of their pension pot to provide themselves with a regular income.
The remaining 25% could be taken as a tax-free lump sum. Pension freedom has been welcomed because the income generated by annuities had become unattractive in recent years due to low-interest rates and increasing life expectancies.
Insurance companies have to invest in fixed interest securities in order to guarantee an annuity income for life. Returns were based on interest rates and on average life expectancies. Capital could not be withdrawn from annuities so if someone died early, the insurance company kept the balance of the capital. Families felt ‘ripped off’ especially if the annuitant died soon after taking out the annuity. However, those pensioners who outlived the average got a good deal.
Now you can decide for yourself how you are going to use your pension pot to sustain you through retirement.
Your main options
Take all your money out. This may seem like the most attractive option but there are a number of issues you should consider first. Don’t forget that although you will still receive 25% tax-free, the remainder will be subject to income tax. Depending on the size of your pension pot and your other income, you could find that by taking the whole amount you end up having to pay higher-rate income tax on this money. Unless you are planning to spend the whole amount on something specific, you will have to decide on alternative investments for your cash. When you consider other investments you will need to bear in mind that you may live for at least 20 or 30 years in retirement so you will need investments that will maintain their real value.
Leave all or most of your money invested and make regular withdrawals from your pension pot. If you leave your money invested in a pension it will remain in a tax-efficient environment where it can grow virtually tax-free. Depending on the type of pension you have already, it may make sense to transfer it to a Self Invested Personal Pension (Sipp) where you can determine the investments for yourself. This is sometimes called a ‘drawdown’ product. A Sipp is also a good place to consolidate past pension schemes so you can manage the money easier.
Leave your pension untouched. Changes in pension rules mean that you can now pass on your pension pot when you die. It will not be included in your estate for inheritance tax purposes. If you die before age 75 it can go to your beneficiaries as a lump sum free of tax. If you die after 75, your beneficiary can take it as a lump sum taxed at 45%. From 6 April 2016, it will be taxed as their earned income, whether they take it as a lump sum or regular income. This beneficial tax treatment of pensions means that it may be better to use up other savings first when you reach retirement, which may otherwise be subject to inheritance tax on your death, and leave your pension invested.