Pension tax trap for people wanting to make larger withdrawals sparks outrage ahead of freedom reforms
Seven out of 10 people find it 'shocking' and 'unfair' when they realise taking full advantage of the Goverment's pension freedom reforms could land them with a surprise tax bill.
Over-55s will be given unfettered access to their whole pension pots from next week, but a new survey reveals low awareness that doing so could suddenly turn them into higher rate taxpayers.
And the response suggests there could be widespread anger once the reforms begin and news sinks in about this tax grab.
Many people who were initially keen to cash in their whole pension had a change of heart once they understood the taxman would take a much larger chunk than if they opted to withdraw smaller sums more gradually, according to the research by Just Retirement and SavvyWoman.co.uk.
Tax tip: Paying more income tax than necessary is avoidable if you take smaller sums from your pension over a longer period
As the start of the reforms approach, pension experts have sounded the alarm that unwary retirees could find themselves heavily taxed for withdrawing big sums from their savings after the launch of pension freedom reforms.
Just like now, only 25 per cent of retirement savings will be tax-free while the rest will be taxed as income. But workers used to simply paying the basic rate of tax through employers might not realise that dipping too freely into their pension will put them into the higher rate tax bracket and on the hook to the taxman for a lot more than they expected.
A separate issue is that HM Revenue & Customs plans to levy emergency tax on people pulling down tax from their pension savings, meaning they might have to overpay thousands of pounds then either apply for a refund or wait until the end of the tax year to get their money back.
But while shelling out emergency tax is likely to be inconvenient, people will at least not be left out of pocket in the long run.
WHAT IS PENSION FREEDOM?
'Pension freedom' reforms will give people greater power over how they spend, save or invest their retirement pots from April 6.
Key changes include removing the need to buy an annuity to provide income until you die, giving access to invest-and-drawdown schemes previously restricted to wealthier savers, and the axing of a 55 per cent 'death tax' on pension pots left invested.
Also, savers won't be limited to one chance to take a single tax-free lump sum worth 25 per cent of their pension pots, with the rest taxed as income afterwards.
Instead, Chancellor George Osborne has announced that people will be able to dip in and make as many withdrawals as they want, each time getting 25 per cent tax-free and the rest taxed like income.
The changes apply to people with 'defined contribution' or 'money purchase' pension schemes, which take contributions from both employer and employee and invest them to provide a pot of money at retirement.
They don't apply to those with more generous gold-plated 'final salary' pensions which provide a guaranteed income after retirement.
Paying more income tax than necessary is also avoidable if you take smaller sums from your pension over a longer period - but if you do mistakenly make a withdrawal that pushes you into the higher rate tax bracket, that extra money will disappear into HMRC's coffers and you will never see it again.
Outrage over pension tax rules
There was a highly negative reaction among adults aged 55-65 to the way tax will be levied after pension freedom reforms, according to the YouGov survey carried out earlier this month for Just Retirement and SavvyWoman.co.uk. The research found:
* Only 34 per cent already knew how much, if any, of their pension savings would be taxed if they withdrew them all at once.
* Seven out of 10 agreed it was 'shocking' that people on average pay - some £29,000 for a 50-59 year old in full-time employment - could only take a £17,850 lump sum from their taxable pension before starting to pay a higher rate tax.
* They disagreed in virtually the same numbers with the view that expecting average earners to pay extra tax was 'fair'.
* Some 68 per cent felt the Government did not make the extra tax clear when they announced the pension freedom reforms.
* The number who said they were 'very' or 'fairly likely' to withdraw their whole pension fell from 17 per cent to 11 per cent after they were asked a few questions about the tax consequences.
* Some 56 per cent of people who described themselves as 'very likely' to withdraw their whole pension pot on the first time of asking were then only ‘fairly likely’, ‘not very likely’ or ‘not at all likely’ to do so or answered ‘don’t know’ when asked later in the survey;
* Regarding emergency tax being levied on withdrawals, 33 per cent said it was 'shocking and unfair', but 48 per cent didn’t mind as long as they got the money back in the end.
Number crunching: Most agreed it was 'shocking' that people on average pay - some £29,000 for a 50-59 year old in full-time employment - could only take £17,850 from a pension before starting to pay a higher rate tax
'Most 54 to 65 year olds we surveyed know they’ll be able to take lump sums from their pensions, but far fewer understand the hidden tax trap – and it could catch them out,' said Sarah Pennells of financial website SavvyWoman.co.uk.
HOW TO AVOID PAYING HEFTY TAX CHARGES
Sarah Pennell of SavvyWoman.co.uk suggests three ways to avoid paying too much tax. She advises people to
* Take some time – ask what is the rush to get your hands on the money.
* Get the free guidance on offer from Pension Wise and talk to an independent financial adviser
* Make sure you know exactly how much tax you would pay on any lump sum you withdraw from your pension before you take it out.
Read more here about how to keep your tax bill down when making pension withdrawals.
'Many people we surveyed do not think it is fair that average earners may have to pay a higher rate of income tax on pension money than they ever paid when they were working - yet in many cases the extra tax will be avoidable with a little planning.'
Pennells said that spreading withdrawals over a number of tax years could save thousands of pounds, while the rest of a pension pot could carry on growing in a tax-free environment but still be accessible.
'There is a danger that some actions that seem like financial good sense such as taking pension money to pay off a mortgage or give lump sums to children could end up handing a large slice to the taxman unnecessarily,' she added.
'It was striking that more than half of those who initially said they were very likely to take their entire pension as a lump sum, were less enthusiastic about the idea once they’d had a chance to consider and answer questions on the likely tax implications.'
Tax test: Only 34 per cent already knew how much, if any, of their pension savings would be taxed if they withdrew them all at once
Stephen Lowe of annuity specialist Just Retirement said people need to be clear about the consequences of making withdrawals from their pension.
'It's your pensions cake but the taxman may want a big slice. People are rightly excited and seeing the possibilities the new rules create, but they have to open their eyes to the pitfalls too. There’s a tax trap waiting to catch the unwary – take care not to get snared.'
How many could get caught in tax trap?
Some 1.7million people who will have access to their entire pension savings from next week don’t know that pension income is taxable and could potentially face a surprise tax bill, according to separate research from Old Mutual Wealth.
But the number at risk could be higher, because one in four people don’t fully understand the tax treatment of pension income – that normally, 25 per cent can be taken tax free with the remaining amount taxed at someone's marginal tax rate.
WHAT IS THE MARGINAL TAX RATE?
This is whatever tax band you are pushed into once all income, including withdrawals from your pension, has been counted.
As with working age people, those above retirement age have a personal allowance, the amount of income allowed before tax is payable. For retired people, this is between £10,000 and £10,660 each year, depending on their age.
They are then taxed at 20 per cent for the next £31,865 of income above this allowance, then any income after that is taxed at 40 per cent, up to £150,000 when the 45 per cent rate starts.
The Old Mutual Wealth survey also shows that only one in four people who will have immediate access to their pension savings have a good understanding of invest-and-drawdown schemes, which are expected to become a far more popular way of generating a retirement income after the pension freedom reforms.
This is nevertheless an improvement on the 17 per cent of people who said they had a good understanding of income drawdown when asked in July 2014.
Meanwhile, 38 per cent of people said they had a good level of understanding of annuities, which provide a guaranteed income for life but have fallen out of favour due to their poor value.
WHAT WILL PEOPLE DO WITH NEW PENSION FREEDOMS?
Some 56 per cent of people who qualify for new pension freedoms plan to make use of them, research from Old Mutual Wealth shows. Among this group, it found:
* 14 per cent will take their 25 per cent tax free cash and leave the rest invested
* 11 per cent will take different amounts as and when they like
* 10 per cent say they will take regular drawdown payments
* 8 per cent will take some of the money from their fund, leaving the rest invested
* 6 per cent want to take their whole pension as cash despite the tax consequences
* 7 per cent say they will take their savings of less than £30,000 under new more relaxed rules on smaller pots
* 14 per cent still plan to purchase some form of annuity.
How many people will seek expert help?
Take-up of the Government’s free Pension Wise guidance sessions is expected to be 41 per cent initially, but will increase to around 64 per cent as awareness grows, Fidelity research shows.
Two out of five retirees also intend to consult financial advisers over the next year, it found.
Pension Wise recently started taking bookings, and it is asking people to come prepared to meetings with some idea of the value of their pension pots, potential state pension, financial circumstances and plans for retirement.
But, further research by Fidelity shows that three out of five people retiring between April 2015 and March 2016 do not know the cost of their essential expenses.
Those who have thought about budgeting expect to spend an average of £777 each month on day-to-day expenses such as utility bills, council tax payments, grocery shopping, TV and telephone services and leisure.
The figure rises to £1,147 for those with a mortgage, and comes to £1,210 for those in rented accommodation.
The comments below have not been moderated.
The views expressed in the contents above are those of our users and do not necessarily reflect the views of MailOnline.
We are no longer accepting comments on this article.