Pensions freedom: beware unexpected tax bills!

The prospect of being able to withdraw as much of your pension as you want from April might be appealing, but make sure you don’t land yourself with an unexpected tax bill.

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If you’re aged 55 or over, then you’ll soon be able to dip into your pension whenever you want. But depending on your income, this could result in hefty tax charges.

Tom McPhail, of independent financial advisers Hargreaves Lansdown, said:

“Recent studies have confirmed that the majority of pension investors do not fully understand how the tax treatment of pension fund withdrawals will work.

“Once the cash has been withdrawn from a pension and the tax has been paid (deducted by the pension provider before the money is handed to the investors), it will be too late.”

How much tax will you pay

You can take up to 25% of your pension as tax-free cash at retirement – that’s been the case for years. But if you want to take out more than this after April 6, then this money will be taxed as income, payable at your highest rate.

Insurer MGM Advantage has crunched some numbers to show just how much tax you might pay, even if you’re on an average income.

If you earn £33,288 in the 2015/16 tax year (the average annual salary according to the Office for National Statistics) and take a £20,000 lump sum from your pension, the first 25% (£5,000) is tax-free.

“Recent studies have confirmed that the majority of pension investors do not fully understand how the tax treatment of pension fund withdrawals will work."

The remaining £15,000 is taxed as your income. Added to your salary of £32,288, this brings your income to £48,288, taking you over the £42,285 threshold at which you must pay higher rate tax at 40%. 

The tax paid on your £15,000 pension payment comes to £4,200.60, at an effective tax rate once different tax bands are taken into account of 28%.

Irreversible decision

Andrew Tully, spokesman for MGM Advantage, said; “Once you’ve taken the money, you can’t change your mind. This is an irreversible decision from a tax perspective, and could leave people wondering why they receive a tax bill further down the line. They may then not have the money available to pay their tax bill.”

The more you take out the more tax you’ll pay. According to Hargreaves Lansdown, if you are earning £30,000 a year, and cash in £90,000 of your pension savings, you’ll be entitled to a £22,500 tax-free lump sum.

The remaining £67,500 is taxable, which means the total tax you’d pay is an eye-watering £24,543, at an effective tax rate of 27%.

What you can do

To avoid being hit by a large tax bill when withdrawing cash from your pension, always make sure you find out exactly how much tax you’ll have to pay BEFORE you take money out. 

You might also want to look at other ways you can use your pension to provide you with an income.

For example, you might want to draw an income directly from your pension slowly over a number of years, or you might want to use some of it to buy an annuity, or income for life.

If in doubt, seek advice from an independent financial adviser. You can find a regulated, qualified IFA through the website, or through the website

Mr Tully said; “At a time when people have access for the first time to possibly the largest single sum of money in their lives, well-informed decisions based on the facts will be crucial in ensuring good outcomes. Proper financial advice will play a key role.’

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