The Essential Guide to Retirement AND TAX FREE PENSION Withdrawl in The UK

Financial Independence and retirement is comprised of two distinct phases, 'accumulation' and 'drawdown'. In the 'accumulation' phase you have not retired in any form and are still building your wealth and working towards your Financial Independence number. 

In the 'drawdown' phase you are drawing on your accumulated wealth to fund your lifestyle for the rest of your life (hopefully!)

The Accumulation Phase

Start Early & Accumulation Phase Tax Relief

The best way to beat the tax man is by starting to save and invest years before retirement, Even if you’re not paying pay tax or earning much income, you can add about £3K a year into a pension and see it boosted, through tax relief, to about £3600. 

It is legal to contribute 100% of your income into a pension each year. With the upper limit of £60,000. With tax relief, you affectively get a rebate of income tax you have already paid. This is the 20% you paid up to the higher rate threshold of about £50,000. Above that level you are getting a rebate on the 40% tax you paid.

Diversification & Investment Returns

This is pretty much the only free lunch when it comes to investing. And in short, means spreading your investments around different types of investments and regions. So for example, if there is a dip in the stock market, not all of your investments will be hit. Spreading your investments across different classes such as property, bonds and equities gives you a better chance of a steady stream of returns, regardless of what's happening in the financial markets and the wider economy.

Forgotten Pension Pots

There is estimated to be around £400 million in lost or forgotten pension pots in the UK. Around 1/4 of all people in the UK admit that they have misplaced some of their retirement savings. People move house and move jobs a lot more frequently in this day and age. 

Old pension schemes may often hold the wrong personal details so it's much easier for people to lose track of old pensions. If you think you have had a pension in the past that you have not kept track of, it's worth trying to track it down. For workplace pension schemes, the government's pension tracing service is a good place to start. It has a database of Over 300,000 pension scheme administrators. 

You need to give them the name of your old employer or pension provider. For personal pensions, contact the Pensions Advisory Service. You can also try the Unclaimed Assets Register (UAR). This is a more comprehensive service carrying out a  whole search for shares, insurance policies and other schemes, as well as pensions. You must Apply Online. This service is run by credit reference agency Experian and charges an admin fee of £25. Visit. uar.co.uk.

There is also another free service aimed at tracking down forgotten savings account... Mylostaccount.org.uk.

Pension Pot Consolidation

Leaving small pension pots in older employee work pension schemes makes it harder to see your full financial position for retirement. These older pension schemes may also lose value through higher pension charges, or invest your money poorly. These smaller pension pots will have charges taken out of them whilst you are not contributing which will erode their value. One of the best ways to organise is to consolidate all of your smaller pensions into one pension scheme. 

This is the simplest and most effective way to keep track of all your pensions and pull them into one account. This will also cut down on paperwork when you retire. In addition, it could save you money. A lot of these older pension schemes. Have complicated or expensive charges which will eat into your returns. It is also possible that some of these old contracts may not allow access to the new pension freedoms which will limit your choices in retirement.

However, some older schemes can come with some valuable benefits, like guaranteed annuity rates that pay you as much as 10% a year. Although these are few and far between. Consolidating or transferring pensions is quite often, a good opportunity. Seek financial advice to gain the best outcome.

The Drawdown Phase (Post Retirement)

Pension Risk

First and foremost don't put your pension at risk! Don't get taken in by fancy funds that have had  a good year and doubled their investors’ money. In retirement, your goal is steady income, not taking unnecessary risks with your retirement fund. 

Keep a track of why you selected your investments in the first place. And only change them if they are not performing as expected. This also prevents your returns being eaten into by the cost of buying and selling funds.

Investing in Retirement - Income vs Accumulation

Many funds that you might invest in usually come in the form of income units or accumulation units. Whichever one you choose, you are still investing in the same fund. In the accumulation phase you are normally better off selecting accumulation units meaning any dividends you receive are reinvested for you. This helps you grow your fund without the hassle of reinvesting money yourself. When you are retired, it may be better to select income units which pays out the dividends instead of reinvesting them.

Withdrawal Strategies & Tax

Don't make the mistake of cashing in your pension in as soon as you can get your hands on it. This could lead to an unexpectedly high tax bill. When you withdraw money from a drawdown pension, 25% is tax free. The rest is treated as normal income and taxed like normal income. 

Taking your pension all at once means you could be taxed at the 40% rate. Even if you've been a basic rate tax payer all your life. In the worst case scenario, it could push your annual income over £100,000 pounds, which would mean your personal allowance of around £12500 would be cut.

The golden rule here is to NOT withdraw more than you need. Remember if you take cash out of your pension fund, it is not growing in that fund anymore. This runs the risk of leaving you short later in retirement. Most drawdown pensions offer easy access to your money in any case. 

However, having a cash buffer for emergencies and basic expenses is a good idea, especially at the start of your retirement to buffer against a few years of bad stock market returns which could cause serious damage to your retirement, and place you at risk of running out of money. This is called the 'sequence of returns' risk.

A TAX FREE PENSION?

The scenario below shows how you can take about £16,000 from your pension, tax free. 

When you draw your pension you are allowed to take 25% tax free with the rest subject to income tax. So, you can take 1/4 of each years withdrawals tax free or you can take a 25% lump sum of the whole pension upfront, tax free. Taking the tax free withdrawals rather than the tax free lump sum means you can keep your pension invested for longer. As long as your pension is growing in value, this would mean that you end up with a greater tax free amount compared to the 25% lump sum up front.

So, £16,000 without paying tax looks something like this: 25% tax free = £4000 pounds.  The remaining £12K is counted as taxable income but it falls within your personal allowance of £12.5K. Note: This scenario does not take account of the state pension which is also counted against your personal allowance, but this only kicks in in your late 60's so this £16K tax free scenario illustrates a tax efficient withdrawal strategy in the UK.

ISA’s

If you have savings outside of an ISA, move them into an ISA to make the most of tax free income. You can put up to £20,000 into an ISA each year. Investment gains, interest, pay outs and withdrawals are tax free. Most ISA's are either a cash ISA, or an equities (or stocks) ISA.

If you have non-ISA savings accounts. you can earn up to £1000 pounds a year in interest, tax free, If you are a basic rate tax payer, and 500 pounds. If you are higher rate tax payer. 

Using an ISA is very important as it allows you to use your personal allowance to the full. Your personal allowance is a taxable income you can receive every year without paying tax, which is currently around £12,500.

Beware the £1Million Pension Cap

There is currently a limit of just over £1 Million pounds which you can build up in a pension scheme. This includes the value of any final salary (or defined benefit) schemes you belong to. Anything 'withdrawn' over this allowance is taxed at up to 55%. 

When you take the excess out as a lump sum, an extra 25% on top of your marginal rate of tax will be deducted when you take it as regular income. This is why it's important to use ISA's (see above) which gives you an equivalent tax benefit (due to not paying tax when you withdraw funds) and helps to keep you below the £1M cap on your pension. You also have 20,000 a year allowance to save into an ISA.

Remember that you can still have more than £1,000,000 in your pension fund. The tax is based on how much you take out. So when you take more than this from your pension that's when the 55% tax kicks in.

Once again, it's important to understand that If you have a final salary or defined benefit (DB) pension scheme, it also counts towards your £1million cap. To get a rough idea of the  value of a DB pension scheme multiply your annual final salary pension payout by 20.

Don't Discount Annuities

You can think of an annuity like a life insurance policy, but in reverse. So rather than paying monthly premiums for a lump sum when you die (life insurance), you pay a lump sum upfront and receive monthly payments until you die. If stock markets crash, you are not affected. If you live till 120, you're fine! However, annuities are a one way street. When you buy an annuity, you are locked in for life. You can't take the money out if you change your mind. 

Another consideration is inheritance. What you spend on an annuity cannot be left to your children or spouse.

Not so long ago, annuities were tainted by mis-selling. However, they can still have their place in a pension portfolio. Annuities provide a certainty that the income will be there as long as you live. 

You can also split your whole pension portfolio into pots. One pot, as an annuity , and the other a drawdown pension. For example, you may use a small chunk of your overall pension portfolio to buy an annuity that will cover your essential bills and leave the rest of your portfolio in income drawdown. For example, if your outgoings are around £11,000 a year and the state pension is around £9000 a year, it could make sense to buy an annuity to give you an income of £2000 pounds a year just to cover your basic expenses so you always have them covered.

There are lots of different types of annuities and lots of variation in interest rates on offer. This is where an independent financial advisor can come into their own, as they can find the best deal for your circumstances. You don't have to stick with the same pension provider you have been with all your life. 

You can use parts or all of your pension to fund an annuity with a different provider if you wish. This is quite a specialised field. For example. It is possible to get an "enhanced" or "impaired life" annuity if you have lower life expectancy or health and lifestyle choices like smoking. If you have any sort of medication or have even slightly raised blood pressure or cholesterol, you could qualify. 

In the UK around six in 10 savers should qualify for an enhanced annuity. But many will not know this. Once again, a financial advisor can pay for themselves here. Common conditions declared include high blood pressure, obesity, diabetes and high cholesterol. For example, a high blood pressure condition could pay up to £3000 more per year. On the flip side, the healthier you are and the better your genes are, the better chance you have of getting value from your annuity as you will live longer. Don't be afraid to disclose all health details to annuity providers to get the best deal.

Also, you can buy an annuity at anytime in your retirement. The longer you wait to buy an annuity, the better deal you will get.

You also have joint annuities that pay an income to your partner or another dependent until they die if they outlive you. You can choose for 100% of the income to be paid or a lower proportion Like 1/2 or 2/3 or 1/3. But ofcourse, the more you choose, the lower rates you will be given on the pay outs when they start. This is particularly helpful if you have a spouse with little or no pension of their own.

Here is a rundown of Annuity Types in the UK: -

• Fixed rate. These annuities pay a fixed rate of income that will not change for the rest of your life. And it's the most common type sold. You start off with a higher level of income. However, the risk is that inflation will erode your spending power.

• Index linked. These annuities grow every year in line with inflation. This helps to preserve your spending power. The downside is that initial payments are usually quite low and you have to live for a long time to get your money back.

• Enhanced Annuities. If you have health conditions or any kind of lifestyle choice, that might shorten your life expectancy then you should declare it when you buy an annuity. This should secure a higher income.

• Guaranteed Rates. Older pension plans can include guaranteed any annuity rates. These offer higher income but many are only sold on a single life basis.

• Guaranteed periods. Most annuities have a guaranteed minimum payment of between 5 or 10 years. If you die after purchasing the annuity, your family or a beneficiary will continue to receive an income for a few years after your death.

Final Salary (Defined Benefit) Pensions

These are generous pension schemes that used to be offered by employers in the UK. In the 'really' good old days when people stayed at the same company for their entire career, they really were a boon for the following reason. They are calculated as the average of the final three years of salary. So if you stayed at one place and ended on a decent salary you were set for life. And, this yearly sum is guaranteed for life.!

These days, they are hard to come by as they are actually very costly for employers to fund. Many employers have stopped offering defined benefit (or final salary) pensions and have switched to defined contribution (DC) Pensions, where they contribute lower amounts(in the long run) along with the employee into a fund which grows over time.  However, many still have defined benefit pension obligations on their books. For this reason, employers are offering rather large sums of money to workers to shed the burden of guaranteed final salary pensions. 

For both current and former employees, if you sell your final salary pensions you are exchanging the guaranteed monthly income for a large lump sum of money.

Defined benefit pensions are also guaranteed to rise with inflation to a maximum of around 5% a year for life. Additionally, there are usually benefits for your widow or dependants. So if you die before retirement age, a lump sum death benefit is likely to be paid. If you sell (or cash in) your DB plan, you give up all of these benefits and expose yourself to the risk of investing your own money.  This could include running out of money altogether ( a.k.a 'longevity risk'). 

Many financial planners would say that cashing in a final salary pension is rarely a good idea. It's a particularly bad idea if you think you're only just going to get by in retirement. Because once you transfer out, it could be a big risk and you won't be able to change your mind.

Another benefit of final salary pensions is that they are effectively backed by the UK Government. The Pension Protection fund guarantees those who have yet to retire, that 90% of their pension will be paid. Even if the employer fails. There is a cap on this, but it is quite generous. For 65 year olds it is around £39,000 per year. So 90% will give you a £35,000 cap per annum.

HOW MUCH CAN YOU GET FOR YOUR DB PENSION? 

So how much are employers offering? In years gone by, this could be as much as 40 times the annual pension. This would mean a £1000 a month pension  could fetch up to around half a million pounds. But it is now commonly held to be around 30 to 35 times. 

If you are considering this route there are a lot of pitfalls. For example, you need to be wary of the pension valuation. You may have left your job with your pension worth £10,000 a year. But since then, inflation may have increased this valuation to around £12,000 a year. So any lump sum offer should be considered in terms of multiples of the current valuation, not the valuation based on when you left your job.

So why would anyone do this? The main benefit is flexibility. Final salary pension still gives you the 25% tax free lump sum, with the rest taken as a regular taxable income. But when you die, the pension payments stop. And so nothing is passed to your children or grandchildren. Transferring out of a final salary pension means you can invest as you like, pay down debts, and pass on anything that remains when you died to dependents. If your investments do well, there's a chance that you can get more money in retirement overall.

WHO MIGHT CONSIDER TRASNFERRING OUT OF THEIR DB PENSION?

Some of the main considerations are...

* Life expectancy. If you and your spouse live a healthy lifestyle. And come from. A family with good life expectancy. Then the security of knowing you will have. Consistent income. Is of high value. Then if you're a heavy smoker with a family. History. Of disease.

Those with a terminal illness or short life expectancy. Your widow might only get half of your final salary pension. But if you transfer out, they could have all of that money. However, if you transfer out, then any life insurance cover included within the scheme will be lost. However, once you have transferred, if you die when you are under 75, then you can give the money to whoever you please. They will inherit it tax free and be able to spend it immediately. If you die when you are over 75, the money becomes taxable at their highest rates when they draw it.

* Single people. If you do not need life insurance and pensions for widowed spouses or dependent children then final salary pensions might be of less value to you. With defined benefit schemes you cannot leave any inheritance to nephews, nieces, friends or others. If you transfer out... you can.

Clearly, cashing in a final salary pension is a complicated affair, and one where you would be well advised to take financial advice. Indeed, you are legally obliged to take financial advice if you want to cash in a final salary worth more than £30,000. That's a pension of about £1500 a year at normal retirement age.

Withdrawal Strategies - Use different pension pots products

There is nothing to stop you splitting your total retirement fund into different pension pots or products. For example, you could put some of your money into an annuity for essential bills. This provides a guaranteed income for life. You could put another portion into drawdown. Where you keep that portion invested so that it grows during your retirement. You don't have to put your entire pension fund into drawdown or annuity.

Pension providers will have different charging structures. Some charge a flat annual rate with others charging each time when you withdraw money.

Don't Forget the non-Withdrawal Strategy (Keep Working in Some Form)

It is perfectly acceptable to continue to pay into a pension after you have started taking money out. So for example, lots of people take tax free lump sum while still employed. However, when you start withdrawing from your pension, the government places a cap on contributions to £4000 pounds per year. Reducing it from the standard £40,000 pounds per year. This is called the lower annual allowance rule. And stops people taking large amounts out of their pensions and then putting it straight back in to claim a second tax rebate.

With regards to the annual allowance itself, it is actually tapered and depends on your income. The rules can be quite complicated and this highlights the need for advice if you have a decent size income.

Withdrawal Strategies – Delay Your State Pension

Delaying your state pension can maximise the amount you can take tax free from private pensions. The state pension is paid without tax being deducted. But it is still counted against your tax free personal allowance. So if the state pension is about £9000 pounds a year. This will reduce your personal allowance to about £3500 pounds.

If you reached state pension age on or after April 6, 2016, Your state pension will be increased by about 6% for every year you defer it. For the full state pension that's about an extra £500 pounds each year. So for example, If you delay taking your state pension for six years, this would (currently) give you an income of around £12,000 a year when you start taking your state pension. And this will be for the rest of your life.

A word of caution, if you receive benefits like income support, Universal Credit or pension credits, you may not be eligible for this delayed state pension top up.

Inheritance Tax Considerations (IHT)

Under current tax rules, pensions have a special status allowing them to be passed on without being counted as part of your estate for tax purposes. i.e. no Inheritance tax or pensions. This only applies to Defined Contribution (DC) pensions. Final salary pensions, or, Defined Benefit pensions usually die with you or your spouse. 

There is a big caveat, however to these defined contribution rules when it comes to inheritance tax. If you die before your 75th birthday, your pension can be passed on tax free and can be spent by your spouse or children without incurring a tax bill as long as they take it within two years. And, they do not have to be over 55, which is the standard cut off point for taking a pension.

However, if you die after your 75th birthday there can be tax implications. In this case, the beneficiaries, or those inheriting your pension, will be taxed at their highest rate, so must be careful how much they take and when. A basic rate tax payer will pay the standard 20% tax. But if the inheritance is sufficient to push them over the higher rate threshold of around £50,000 per year then any money over this level will be taxed at 40%.

Splitting your pension: Inheritance amongst a number of dependants. May help with this tax burden. In the worst case scenario, an inheritor, or beneficiary, might inherit so much that they could take out over £100,000 pounds in income and would therefore then lose their personal allowance of around 12,500 pounds tax free. 

However, this situation can be avoided by leaving the pension invested and taking it gradually. There is no need to take an inherited pension all at once. So if you die over the age of 75 the inheritance can be taken in phases, reducing the tax bill.

Isa’s & IHT: If you die with anything in an ISA, you can pass that onto a spouse, tax free. If you want to give that inheritance to children or others, then it will be counted as part of your overall estate and will count towards your inheritance tax nil rate. Which is currently around £325,000 pounds. i.e. any funds over £325K are subject to IHT.

Property allowance: On top of the IHT nil rate band of £325,000 there is a £175,000 pounds allowance for the sale of a property after you die. So currently this means a property owner can leave around half a million pounds in inheritance which is tax free.

UK Pensions and Retirement 'Blogroll'

I hope the article above was a good primer into the world of retirement options available to UK citizens. The websites below are great starting points for further reading and should help with retirement decisions.

UK Government 

• Retirement Living Standards (find out how much you need to live on in retirement)

Non Government 

• Money Facts Retirement Planning