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Lower annuity rates may lead to more people taking money out of their pension flexibly – but the tax consequences should be borne in mind.

Background

Annuity rates have plummeted in recent years and continue to fall to all-time lows in the wake of the ‘Brexit’ referendum vote. This may lead to even more people seeking to take money out of their pension flexibly, under the relaxed rules introduced from 6 April 2015. If you are thinking about doing this, be aware of the possible tax consequences and the impact on other entitlements such as tax credits and child benefit.

You may be able to draw money out of your ‘pot’ very flexibly – as much as you like, when you like, from age 55 – if you have what is known as a defined contribution pension savings scheme (rather than a scheme that is based upon your salary as an employee) and your provider allows you to. Many people have already taken advantage of this ability and more are likely to do so as annuity rates fall further.

But do not rush. A hasty decision could cost you heavily in the form of an unwanted tax bill and even a tax credits/benefits overpayment.

What tax and benefits issues do I need to watch out for?

The Low Incomes Tax Reform Group suggests you read its guide in full (see Useful Links at the bottom of this page); but some key points are highlighted below:

1. Tax on the amount taken from your pension

Usually only 25% of any amount that you take out of a pension is tax-free. The rest is taxable income, so it is added to other income that you have and you will have to pay tax on it. It will probably give you an extra tax bill and the extra income could tip you into a higher tax rate, and/or could mean that you are no longer entitled to extra tax allowances.

The exact way in which this works does depend, however, on how you use your pension. For example, if you have a £40,000 pension pot and you want to take out £10,000, you might be able to either:

• take £10,000 tax-free (25%) and then draw on the remaining £30,000 as fully taxable income at a later date; or
• take £10,000 out, of which £2,500 (25%) is tax-free and £7,500 is taxable income, and then 25% of the remaining £30,000 will be tax-free when you take it out later.

You might also have to claim some tax back, or pay extra tax, depending on the amount deducted through Pay As You Earn. And you might have to fill in a self-assessment tax return.

2. Other tax consequences, for example loss of ‘allowances’

There could be knock-on effects to the tax rate you pay on other types of income. For example, in 2016/17 there is a new ‘personal savings allowance’ (or ‘savings nil rate’) which means you can have either £1,000 or £500 of tax-free savings income depending on whether you are a basic rate or higher rate taxpayer. If taking money out of your pension makes you a higher rate taxpayer, you will therefore lose half of this allowance, costing you up to £200 in tax.  

3. Tax credits – possible loss of entitlement for two years

The amount taken from your pension that is taxable is also counted as income for tax credits, so it can affect your award for both the year in which you make a withdrawal from your pension and the following year, and could cost you dearly. You could lose part – or even all – of your tax credits for the year you take money out of your pension and the following year.

4. Child benefit – possible high income tax charge

One further thing that might be overlooked is the impact on child benefit.

Child benefit is not in itself a means-tested benefit. This means that anyone with qualifying children can claim it. But there can be a linked tax charge on you (or on your partner if you are part of a couple) where your (or your partner’s) income is over £50,000. This is called the ‘high income child benefit charge’ (HICBC).

This is not something that most people on low incomes usually have to worry about, but it could become a problem when taking sums out of your pension pot if it tips your total income over the £50,000 limit.

5. Other state benefits – possible loss of entitlement

You should check carefully the impact of your pension decisions on means-tested state benefits, such as universal credit and pension credit – both in terms of current and possible future entitlement.

One-off or irregular sums taken from pensions could be treated as ‘capital’ for the purposes of means-tested state benefits, and regular amounts taken from pensions are likely to be treated as income. Either capital or income treatment could have an immediate effect on your entitlement to state benefits, depending on your overall circumstances.

‘Local’ benefits like Council Tax Support could also be affected.

The Department for Work and Pensions has also published a factsheet, available on GOV.UK – this considers how the pension flexibilities could affect entitlement to state benefits.

Who do I need to notify that I have taken money out of my pension?

If you do decide to take advantage of pensions flexibility, you might need to notify:

• HMRC – for tax consequences, including a high income child benefit charge
• HMRC’s Tax Credit Office – if you are a single or joint claimant of tax credits
• The Department for Work and Pensions – if you claim state benefits administered by them
• Your local authority – if you claim local benefits such as Council Tax Support

Further information can be found in the LITRG guide.

Where can I find out more about taking money out of pensions?

The LITRG has written a guide covering the main tax and related benefits consequences of taking money out of your pension flexibly – it can be found in the pensioner section of the LITRG website.

Annuities may still be an option for some people. Taking income from a pension in the form of an annuity gives you extra taxable income, so many of the same issues above could apply.

Before making a pension decision, you will need to bear in mind all the possibilities of planning for the rest of your life, considering carefully things as they are now and how they might be in the future – not only your tax and benefits position but also, for example: your personal circumstances; probable needs; family situation; life expectancy; other sources of income; and any other factors you think might be relevant. You should seek guidance from Pension Wise – a free service provided by the government, which can help you with the bigger picture of whether an annuity is a suitable vehicle for you or whether other routes may be appropriate.

Finally, be wary of other organisations offering ‘free’ pension reviews. Scams relating to pensions are extremely common – a helpful list of pension scams to be aware of can be found on the Pension Advisory Service website.

Useful links

LITRG article with various links, notably to the Department of Work and Pensions factsheet on pension flexibilities and DWP benefits, to the LITRG guide on Pensioners and Tax, to the Pension Wise website and to the Pensions Advisory Service.