5 costly mistakes to avoid when you cash in your private pension
Planning for retirement is often a complex task, particularly when it comes to cashing in your private pension. There are many different options to choose from, and because of this, it can be easy to make a costly mistake if you take the wrong course of action.
From additional tax charges to running out of money, the stakes are high when you’re managing your pension. So, by being in the know, you can protect yourself from these five common mistakes that could cost you in the long run.
1. Incurring additional tax charges by withdrawing more than 25% of your pot
When you are able to start withdrawing from your pension pot (this is currently age 55, but will soon rise to age 57 from April 2028), you are usually permitted to withdraw 25% of your savings as a tax-free lump sum.
What many people don’t realise is that any withdrawals above this amount could be liable for Income Tax at your marginal rate. This means that if you take more than your initial 25% tax-free lump sum, you could be taxed at a higher marginal rate if it pushes your income for that tax year into the next Income Tax band.
So, it’s important to keep track of how much money you are withdrawing from your private pension so that you don’t pay more tax on it than is necessary.
2. Withdrawing more than you need
If you opt to use flexible drawdown to cash in your private pension, it can be tricky to balance taking enough of an income to live on with keeping enough saved to last for the rest of your life.
This is why planning your finances for retirement can sometimes be compared to climbing Mount Everest: descending from the summit is often far more treacherous than the ascent. By the same token, saving up for retirement is relatively simple compared with the task of decumulating after you have entered retirement.
In the worst-case scenario, you could withdraw too much cash at the start of your retirement and risk running out of money in later years, particularly if you require later-life care which can prove costly.
There are some generic rules of thumb that you may have heard regarding how much of your pot you should withdraw each year to avoid running out of money later on. The “4% rule” is one of them, suggesting that you withdraw 4% of your total pension pot in the first year of your retirement, and then continue to withdraw the same amount each year following. Some financial planners have suggested that the percentage should be closer to 3%, and some 5%.
In reality, generic rules of thumb are rarely personalised enough to be suitable for your circumstances.
Factors such as your preferred lifestyle, inflation, and your investment returns, among others, all affect how much is a suitable amount for you to withdraw each year. Instead of following commonly heard theories, it is sensible to consult with a financial planner who can help you to reduce your risk of running out of money in later life.
3. Exceeding the Money Purchase Annual Allowance
If you have already started to take a flexible income from your pension pot, there are limits on how much you can then pay into the fund tax-efficiently. This is known as the Money Purchase Annual Allowance (MPAA) and in the tax year 2023/24 the limit is £10,000.
This is particularly important if you are planning a phased retirement or if you decide to return to work after retiring.
Phased retirement is becoming a more popular way of transitioning from full-time work into retirement, as many people opt to reduce their hours gradually or take on ad hoc work. Research shared by Legal & General found that, in 2022, 34% of over-55s who were still in work had begun to reduce their hours in anticipation of taking full retirement at a later date.
If you use your income to make further contributions to your pension that exceed the MPAA, you could incur an additional tax charge. Keep track of the contributions you are making to be sure that you don’t accidentally find yourself in this position.
4. Buying an annuity without shopping around
An annuity can be a helpful way to ensure that you have a guaranteed income in retirement and, as interest rates rose in 2022, so did annuity rates. This has made them an attractive proposition for retirees who want to have a stable income in retirement.
If you are thinking of buying annuity with your pension money, it’s important to consider all the available options before committing. Research conducted by Which? has found that shopping around before you commit to an annuity product can mean you are 20% better off during your retirement.
There are lots of different options to choose from. Some annuities can be linked to inflation, so your income increases each year to keep pace with rising prices. You could guarantee payouts for a set number of years, or you could choose for your spouse to receive 50% of your original annuity income in the event of your death.
The key thing to remember is that, once you have bought an annuity, it’s not normally possible to change your mind or amend the terms of the product. So, think carefully before locking in your deal and be sure to check what else is out there rather than settling for the first provider you see.
5. Not taking professional financial advice before retiring
Cashing in your private pension is likely to be one of the biggest financial decisions you make in life. Yet, according to figures shared by the Association of British Insurers, over half (52%) of the people who accessed their pension in 2022 did so without seeking any kind of professional financial advice.
Accessing your pension without taking advice from a financial planner could lead to you losing money by accidentally incurring additional tax charges or by committing to the wrong financial products for you.
According to research published by Standard Life, individuals who don’t seek financial advice expect to be able to fund their retirement for a maximum of 17 years – but this number jumps to 23 years among those who did speak to a financial planner.
The same study also discovered that 23% of people who did not take financial advice have found that they need more money in retirement than they anticipated, compared to 19% of people who did take advice.
This shows how even a standalone appointment with a financial planner could be enough to help you avoid costly mistakes in accessing your pension and give you the potential to increase your financial wellbeing during your post-work years.
Get in touch
If you’d like to learn more about the most appropriate way to access your pension savings as you approach retirement, we can help.
Email info@informedpensions.com
Call 0880 788 0887
Please note
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.