Q: I am approaching retirement and want to better understand my options with regards to my pension pot. There has been a lot in the news about cashing in a pension and taking all the money although it is reported that a lot will disappear in tax. I do not really understand the tax side can you explain?
A: As from 6 April 2015 the options available to people who are ready to draw their pension have increased. In the past the typical route would be for someone to draw their tax free lump sum from their pension pot and then purchase an annuity with the remainder. The tax free maximum was, and still is, 25% of the pot (although there can be exceptions to this). An annuity is an annual retirement income that is paid to an individual for the rest of their life.
The retirement income that is received will be subject to income tax and forms part of the individual's total income each year. This means that the gross pension income received plus other income such as the state pension, investment income, income from let property etc. will be added together to work out the rates of tax payable. If the total income amounts to £42,385 or less (2015/16) then tax will be due at 20% i.e. the basic rate. To the extent that income goes above this level then the excess will be taxed at the higher 40% rate.
The new pension rules allow an individual to dispense with the requirement to purchase an annuity and they can draw down lump sums from the pension pot. Once the tax free element has been drawn then additional lump sums will be subject to income tax in the same way that retirement income paid from an annuity is taxed. If the whole of the pension pot is drawn in one tax year then potentially a lot of income tax will be paid in one go. This is because a large lump sum may increase an individual's total income for a tax year above the £42,385 basic rate income level and will mean tax will be due at 40% rather than 20% in situations where the income is drawn in smaller amounts over the course of a number of years. A very large pension pot that is drawn as a lump sum which takes total income above £150,000 will be taxed at 45% on the excess over that level.
Whilst having the freedom to draw lump sums rather than purchasing an annuity may be considered a good thing it will be very important to understand the tax consequences and potentially plan the draw down over a number of years.