Temptation for early withdrawal of pension savings could lead to higher taxes

Published by Bhargaw Buddhdev on

The Chancellor announced a shake-up of defined contribution (DC) pensions in March’s Budget.  From 6 April 2015, individuals will have greater freedom and choice in accessing their DC pension savings. 

The new flexibility means people over 55 can choose how they access their pension savings; for example they could take them all as a lump sum, draw them down over time, or buy an annuity.  However, individuals will need to carefully consider the tax implications before they make any decisions.

For example, imagine a wealthy high earner named Mr O.S. Borne. Mr Borne is aged 56 and is about to retire from working. He has a £1 million pension pot and income from other sources.

If he feels encouraged by the new freedom to take all his benefits in April 2015, he will receive the following from his pension savings:

  • £250,000 tax free cash from his pension fund (i.e. 25% of his pension pot)
  • £750,000 taxable cash – he will pay tax of approximately £330,000 and receive the net sum of £420,000

Therefore, in year 2015-2016 he will receive a lump sum of £670,000 from his pension pot and pay £330,000 tax.

"Individuals will need to carefully consider the tax implications before they make any decisions."

In many cases high earners like Mr Borne can afford to take little or no benefits from the pension scheme as they have other assets to live on. These other assets are accruing income and hence income tax and capital gains tax is payable. Therefore, it is often beneficial to use these assets for income needs and not draw any income from pension fund assets, where investment gains are not taxed.

Recent changes to the taxation of untouched pension benefits make this option even more attractive. For example, If Mr Borne takes all his benefits as cash, reinvests the total £670,000 alongside his existing assets, and those assets earn income of 4% per annum, in future years he could receive an income of £26,800 from the pension lump sum which will be taxed at £12,000 per annum. In the event of his death all of his funds are now part of his estate and will be taxable at 40% (under current legislation) before they can be passed to his beneficiaries. This could potentially mean a further tax of approximately £268,000.

If Mr Borne chooses instead to leave his benefits in the pension fund, then he could save even more tax:

  1. he does not need to pay the £330,000 tax for cashing in the pension fund
  2. he does not pay the tax of £12,000 per annum on each year’s investment income (further, the investment income will be reinvested and could be expected to grow)
  3. if he dies before he draws any income from his pension fund the full fund of £1 million, plus any investment growth, is payable to beneficiaries (saving another £268,000 of tax)

Of course investments can fall as well as rise, and Mr Borne may well wish to review the way his pension savings are invested in order to preserve their capital value.

The pensions system has been changing at a rapid pace in recent years, particularly for high earners who have faced increasing restrictions on the amount they can save.  The new flexibilities offer welcome opportunities for well-informed individuals to manage their income needs and taxation affairs.  Senior staff can often benefit from expert advice from someone who understands all the issues.