You have saved all your life for your retirement fund and now, thanks to major new changes to the pension rules, you get complete freedom on how to spend it.
The biggest shake-up in the history of pensions has started. Changes to the rules mean that you will have complete control over your money, and greater power over how you spend, save or invest the retirement pot you have built up over many years.
For the first time, you will be free to choose how you use the money you’ve saved, without any restrictions. This might mean you use some of it to pay off your mortgage, enjoy the holiday of a lifetime, put down a deposit on a holiday home, or fulfill a big lifetime ambition you have had for years.
Anyone over 55 will be able to dip into their pension fund and use the money as they wish. On the one hand, it’s great news, because you will have complete control over the money that you’ve worked so hard to accumulate and save.
On the other hand, you are going to need to make some important decisions about what you do with your fund – and to think about how you are going to make your pension money last you for the rest of your life.
Big changes are happening to pensions
For many people, the biggest change is that they are no longer forced to turn their pension cash into a fixed income for life, known as an annuity. Instead they can dip into their pension fund and take out cash as and when they need it.
In fact, they can take 100% of their pension in cash if they wish to do so. The question is, should they? According to a recent survey, holidays, cars, and home improvements come top of people’s wish-lists for spending a portion of their pension cash.
New research from Ipsos Mori suggests that 12 per cent of retirees plan to take their pension all in one go. However, this may not be the best idea, because if you take all your pension at once you are likely to trigger a big tax bill.
What the new rules mean for you:
Under the new rules, you are allowed to:
- Take 25 per cent of your fund tax-free and leave the remainder invested
- Or withdraw anything from 0 to 100 per cent of your pension money
- Or leave all your pension invested, and dip into it from time to time, with the first 25 per cent of all withdrawals being tax-free. This is known as ‘income drawdown’.
- Alternatively you can buy an annuity
- If you die, you can pass on any unused part of your pension which is still invested and not have to pay a 55 per cent death tax (which used to be levied on pension pots).
Why you need to watch out for tax
It’s really important, however, to look at your tax position when you are deciding what to do about a pension. When you get a pension you pay tax on any income above your tax-free Personal Allowance (this allowance is the money you are allowed to earn before you pay any tax at all).
Any withdrawals above the 25 per cent tax free cash will be taxed as income.
How much income tax you pay depends on the tax rate that applies to you. For example, if you are a basic rate tax payer you may be pushed into paying higher rate tax if you take all of your pension in one go.
Don’t forget other sources of income which include the State Pension, private pensions, employment, or income from property or investments and savings. You’ll have to pay tax on any annuity payments you receive if you decide to buy one.
Annuities guaranteed an income for life, but they had become unpopular in recent years because they were regarded as offering very poor value. So many people warmly welcomed the freedom to withdraw pension cash as and when they wished, subject to certain tax rules and restrictions.
In fact, when the new proposals were unveiled last March, the Lib Dem pensions minister Steve Webb said that people approaching retirement should be free to blow their pension pot on a Lamborghini if they so wished.
However, given that the average UK pension pot is £72,000 (according to researchers at IRESS, which processes annuity sales through financial advisers), and a newLamborgini costs around £180,000, the number of retirees taking this route is going to be very small.
Who’s eligible for the new pension freedoms?
- The changes apply to anyone who has a ‘defined contribution’ (DC) or ‘money purchase’ pension schemes. These schemes take contributions from both employer and employee and invest them to provide a pot of money at retirement.
- If you have a ‘final salary’ pension, sometimes known as ‘defined benefit’ or DB scheme, which provides a guaranteed income after retirement, then the changes don’t affect you.
First of all you need to check what sort of pension you have, and whether it can be cashed in at all. You can do this by talking to your employer or pension fund provider.
How can you make the most of the new pension freedoms?
Although the changes give you lots more control, you also need to make some choices which will affect your income and standard of living for the rest of your life.
You need to calculate how much money you need to live on, and how healthy you are.
What will you do with your cash-free lump sum? Do you need to pay off the mortgage, or bolster your retirement savings with it, or do you have the flexibility to spend some of it on treats you’ve always dreamed off, like a new car or a holiday home?
Deciding what to do with your fund is very important because that money will need to last you for the rest of your life. That’s why it is important to get proper impartial information from an organisation like Pensions Wise (www.pensionwise.gov.uk) which can take you through all the options. There is a website, helpline and face to face advice.
Here’s a checklist from Pension Wise on how to make the most of the new freedoms:
- Check the value of your pension pot
- Understand what you can do with your pension pot
- Plan how long your money needs to last
- Work out how much money you’ll have in retirement
- Watch out for tax
- Shop around for the best deal