One way people can keep more of their hard-earned money is by paying less tax, however prioritising tax efficiency over growth potential is “one of the biggest pension mistakes” people make, the expert said. On his Youtube channel, financial planner Chris Bourne explained how people can balance these two concepts to provide “a great lifestyle in retirement”.
He said: “People assume they pay 55 percent because that’s the headline rate that they have heard, but in most cases, they will pay 25 percent.
“You only pay 55 percent if you take all of the excess out as a cash withdrawal.
“If the funds are transferred into a drawdown plan, the excess charge is 25 percent.”
Income tax will then be paid on funds taken out of drawdown, but people do not have to withdraw any cash out.
To avoid paying extra inheritance tax, people can decide to leave the money in drawdown for “as long as possible” as it is not due on pension holdings.
He said: “Limiting the amount of growth you can achieve just to avoid paying more tax is pointless.”
Mr Bourne gave an example. If someone is already £100,000 over their lifetime allowance and they do not want to make the tax charge any worse so they invest their money in a way they only get one percent growth, they will lose out.
Over 10 years, their £100,000 will be £110,462, but if they crystalized their whole pension pot, and transferred the excess into drawdown, the tax would be £27,615 (25 percent), leaving people with a net excess of £82,846.
If these funds kept on growing and there was five percent annual growth, over a 10-year period, the £100,000 excess would have grown to £162,889.
The tax charge on this amount would be £40,722 (25 percent), which is more money, but the net excess would be £122,166.
This is a £40,000 improvement.
He added: “Always try and get the best performance you can within your risk profile.
“Don’t cut your nose off to spite your face by avoiding growth.”
Additionally, another “big retirement mistake” that people make stopping pension contributions prematurely in order to solely fund ISAs.
He explained that people may do this because they realise that any gains can be taken out of ISAs tax free, whereas pension withdrawals are subject to income tax.
He said: “What they fail to appreciate though is the power of compound interest on the tax relief rewarded on top of their pension contributions.
“This is money physically added to pension contributions for you by HMRC.”