The biggest change in the pension rules that certainly I have ever seen is about to take place. From April 5th anyone over the age of 55 will be free to cash in their Defined Contribution (DC) pension pot. Previously people were required to take out an annuity which would have paid a set amount each year.
The big issue that has been less well highlighted is the tax implications for those that do decide to cash in their nest eggs.
People can take a tax free lump sum of 25% but will be liable for income tax on the rest. This means that when your annual income exceeds £42,386 you will be paying tax at the higher rate of 40%. If you can keep your income below the higher rate tax threshold you will pay less tax.
As an example: A person drawing a £125,000 pension pot would pay this level of tax:
£125,000 total pension
25% tax free = £31,250
He would be allowed the annual tax free allowance of £10,600
The remaining £83,150 would be taxed as follows
20% on £31,785 = £6,357
40% on £51,365 = £20,546
So a total tax bill of £26,903 – Ouch.
It would therefore be far more tax efficient in this case to stagger payments over multiple tax years to avoid the high tax charges of taking this all in one go. Many people seem to be unaware that taking the entire pot straight away may trigger a big tax bill. This means it could be a bumper year for the tax man!