Pension savers risk a shock tax bill as a growing number of over-55s withdraw their entire pots to keep up with the rising cost of living. Basic rate 20 percent taxpayers could get pushed into a much higher income tax bracket unless they plan carefully.
Since 2015, Britons have been free to make pension withdrawals from age 55, of which 25 percent can be taken as tax-free cash.
However, any further withdrawals will be added to your total earnings for that financial year, and subject to income tax.
Now pension experts are warning the over-55s to plan pension withdrawals carefully, or they could hand over a staggering 40 percent or 45 percent of their pot straight to the taxman.
This brutal level of tax could even be imposed on people who are normally basic rate 20 percent taxpayers.
They could find themselves tipped into a higher tax bracket after making a large one-off pension withdrawal.
This is a particular danger when people withdraw their entire pension in one go, rather than taking it over a number of years.
More than half of all pensions accessed for the first time last year were fully withdrawn, often without taking independent financial advice.
There was also a sharp increase in the number of pension withdrawals worth £50,000 or more, analysis from financial advice firm NFU Mutual shows.
In the 2021/22 tax year, more than 700,000 over-55s accessed their pensions for the first time. Of these almost 400,000, more than half, chose to go fully withdrawn, according to Financial Conduct Authority data.
While more than 260,000 were for smaller pots of less than £10,000, the number of pensions over £50,000 that were fully withdrawn jumped 15.5 percent to 17,661.
READ MORE: Fears grow over ‘nightmare’ 55% pensions tax – may hit more savers
Worryingly, more than 10,000 of these withdrawals were taken without advice, and many could fall into a tax trap.
Sean McCann, chartered financial planner at NFU Mutual, warned that fully withdrawing a pension can backfire. “Cashing in pension pots of more than £50,000 will push many into the 40 or 45 percent income tax bands and leave them with a large tax bill they weren’t expecting. It will also limit their funds for the future.”
This “unnecessary” tax bill can be reduced by phasing withdrawals over a number of years instead of taking it in one go, he added.
Another problem is that some people cash in their pension funds without a clear idea of what they plan to do with the money, often putting it into a bank account.
By doing this, you will lose pension tax advantages, McCann warned. “You may expose any future growth on the money to income tax, capital gains tax and potentially inheritance tax, too.”
Martin Lewis shares ‘little-known benefit’ to add thousands to pension [REVEAL]
‘Dangerous game’ to rely on state pension payments [INSIGHT]
State pension triple lock is Liz Truss’ ‘bone of contention’ [ANALYSIS]
For those who have others savings and investments such as ISAs, it could make more tax sense to draw pension funds last, as they can be passed on to loved ones free of inheritance tax.
Another danger is that once you have made early withdrawals, the amount you and any employer can invest into a pension shrinks to just £4,000 a year, under the money purchase annual allowance (MPAA).
Anyone accessing their pension earlier than planned or taking bigger withdrawals must consider whether this is sustainable, warned Tom Selby, head of retirement policy at AJ Bell. “While in some cases this may be the only option, take time to consider how decisions taken today will impact your finances further down the line.”
As a rough guide, experts usually say a healthy 65-year-old can safely withdraw up to four percent of the value of their fund each year and be confident it will last throughout their retirement, Selby said.
It depends on factors such as your age and pension pots. “Someone who is accessing their pension, say, in their mid-70s, can withdraw a higher amount sustainably.”
Pension withdrawals are complicated so consider taking independent financial advice.