In less than a month, the way we save for our future will be revolutionised.
The government has announced dramatic reforms of the pension system over the past year and from 6 April 2015 people who retire will have far more flexibility over what to do with their pension savings.
The most important change is that once you turn 55, regardless of whether or not you have retired, you'll be able to take as much or as little as you like from a 'defined contribution' or personal pension, with no obligation to purchase an annuity.
After 5 April, it'll be down to you to decide how best to use your pension pot. You could:
- Withdraw all of your pension savings in one go and invest, save or spend them as you see fit (regardless of how big or small your fund is).
- Purchase an annuity, either at retirement or later on, and turn some or all of your pension pot into a guaranteed income for life.
- Keep your savings invested, while dipping into them over time - this kind of product is known as a drawdown.
No matter how you decide to manage your money at retirement, any funds withdrawn will be added to your annual income and taxed accordingly, dependent on your income tax band. However, the first 25% of any lump sums taken out of a pension will be tax-free.
If your annual income exceeds around £10,000 the tax rate could be set at 20%, 40%, 45% or a combination of these rates, dependent on how much cash you want to access.
To help you figure out how best to take your pension pot, PayingTooMuch.com has highlighted some key points to consider when deciding how to handle your pension freedoms.
1. An annuity offers peace of mind
One of the most talked-about aspects of the upcoming reforms is that they mean people will no longer have to buy an annuity when they retire.
Annuities have been criticised over recent years because of falling rates and because they are generally irreversible.
But an annuity is nonetheless the only way of getting the peace of mind that you will continue to receive an income from your pension for as long as you live. If you don't have any other means of financial support in your old age apart from the state pension, an annuity is well worth considering.
2. Don't get caught in the tax trap
Another important aspect of the reforms are the changes which allow savers to withdraw money from their pensions as a lump sum whenever they like.
But this could have serious tax implications: if you take your whole pension as cash as soon as you stop working, you could face a big tax bill for that financial year.
Depending on the exact timing, you may find that your tax office adds your pension withdrawal (minus the 25% tax-free lump sum) to whatever salary you have earned in that year before calculating your income tax bill.
As a result, you could end up paying 40% or even 45% tax on most if not all of your pension.
A better strategy could be to stagger your withdrawals over a longer period of time.
3. Investment growth can make your retirement more comfortable
From 6 April it will be easier to leave your pension invested in the stock market and other assets while taking a regular income after you retire, through a drawdown scheme.
This option does have potential downsides: if you take too much income or your investments perform poorly, you could run out of money.
But by leaving your pension invested, you remain open to the possibility that investment growth will boost its size and give you a higher level of income later in life.
This is the key risk that many individuals will face. One way of dealing with this risk could be by using some of the fund for drawdown and the rest to buy an annuity: this means there will always be a guaranteed minimum income level, with the drawdown scheme hopefully adding some extra money as well.
4. How to seek help
What you do with your pension is likely to be one of the most important financial decisions you ever make. The new freedoms, while largely welcome, mean there is greater scope for things to go wrong.
That is why it makes sense to consider seeking some kind of expert help.
The government is providing free, impartial, broad guidance through its Pension Wise scheme, which will be available online, over the phone or through face-to-face meetings.
But for in-depth advice taking into account your own personal circumstances, you need to pay an independent financial adviser (IFA). To find an adviser near you, consult the IFA directory at unbiased.co.uk.
