How to use your pension pot like a bank account
From April 6 retirees will be able to dip in and out of their pensions savings
Each ‘withdrawal’ qualifies for 25% tax-free
Untouched savings can be kept invested
In April 2015 the way millions of savers plan their retirement will change forever.
The pension freedom changes, first announced in this year’s budget, are coming into force and will radically alter the landscape for savers. As a result of the changes, savers who would previously have bought an annuity will now have a whole raft of new options.
Keep your pension and dip in
The most fundamental change is that savers will now be able to use their existing pension as a bank account and make withdrawals whenever they want. 25% of every sum taken out is tax-free while untouched pensions can be kept in the stock market to grow. This amazing benefit means that a couple of years of good growth can cancel out the amount withdrawn.
Let’s assume someone, takes their pension at 65, and receives the average state pension of £130 per week (£6,760 per year). This tax year you get an annual personal allowance of tax-free earnings of £10,000 (increasing to £10,500 next April). That leaves £3,740 to use up after state pension payments. Our retiree has a £100,000 pot and wants to withdraw £5,000 per year. The first 25% (£1,250) is tax-free and therefore the remaining £3,750 is taxable, but is mostly covered by the remaining £3,740 of personal allowance.
The final £10 is taxable at the basic rate of 20% giving a total tax bill of £2.
This saver now has £95,000 left in their pension. We’ve assumed investment growth (after charges) of 5% a year which means that after 12 months their fund has grown to £99,750. At this rate, you should easily be able to live off your pension pot for the rest of your life.
Many people, though, will need more money to live off and may wish to take a larger sum, say £10,000, from their pot each year. Again, the first 25% (£2,500) they withdraw is tax free and the remaining £7,500 is taxable. £3,740 of this is covered by their tax free personal allowance and the remainder (£3,760) incurs basic rate tax of 20% giving a total tax bill of £752.
After 12 months the £90,000 remaining in their pension pot has grown to £94,500 (assuming 5% growth) but it is worth noticing that taking this larger sum would mean that the pension would be spent by the time the saver was 80.
Take your 25% tax-free lump sum
Currently, eight in ten savers takes 25% of their pension pot at retirement as a tax-free lump sum. The money is often used to pay off debt or buy a new car or expensive holiday. It’s thought many people still will want to do this under the new regime, but may want to keep the remainder invested.
Under the new rules, you can still take your lump sum, but there is an added complication. You’ll have to move the remainder into a special type of pension, which is called a drawdown account. These can be costly due to fund fees and administration costs but this option is likely to be popular with those who have additional income such as a final salary pension.
In this case we’ve assumed that the final salary pension is £2,500 a year. With the average state pension (£6,760 per year), that gives a total annual income of £9,260 leaving an additional £1,240 of tax-free income. Using the same original £100,000 pension pot (minus £25,000 taken tax-free), if you then took a lump sum of, say, £20,000 at the end of every 5th year, each withdrawal would be taxable, because you’ve already had your tax-free cash allowance.
So, in total, you’d pay £3,752 in basic rate 20% tax each time you made a withdrawal.
The advantage of drawing money at longer intervals is the compound interest of your investment growth of 5% a year after charges. After 20 years, you’d still have £73,331.
Buy an annuity – guaranteeing an income for life
For many people, the biggest fear of the current pension revolution will be of running out of cash. For them, buying an annuity, which pays a guaranteed income for life, could still be the best option.
A 65-year-old in good health could expect an income of £4,360 a year in exchange for a £75,000 pension pot (after taking a 25 % tax-free lump sum). Added to the average state pension, that’s an annual income of £11,120, with just £620 taxable.
For those with a reduced life expectancy, that income could be even greater; in some cases, as much as £1,000 a year more, if they choose an enhanced/impaired annuity that pays out at a higher rate over a shorter period.
There may also be an increase in people taking different types of annuities — for example, fixed-term deals that pay a set income for a set number of years, allowing you to review your financial situation at a later date.
There are also investment-linked annuities, where the income paid is linked to the stock market and other assets. This means it could go up or down depending on how well shares, bonds and property are doing that year.
But, as today, a major downside of an annuity for many savers is that once you’re committed, no one can inherit the money when you die. A solution to this, and one which many experts think will be increasingly popular, is to take some of your pension as an annuity and keep the rest in a pension where you can take it as cash.