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The coronavirus crisis has had an impact on everyone’s finances – for better or worse – and many over-55s have been forced to turn towards their pension to plug the income gap.
"Drawing down" from your pension, however, can come with a hefty tax bill so it’s important to understand the implications of dipping into your pot.
Whether you are still paying into your pension, approaching retirement age or already a pensioner, there are several tax pitfalls to avoid.
1. Understand your tax relief entitlement
Claire Trott, of wealth adviser St. James’s Place, said the first step was to make sure you understood your pension scheme and how you received tax relief on it.
Anyone who is over 22, employed and earning £10,000 or more will be automatically enrolled into a pension scheme chosen or run by your employer. A minimum of 8pc of your earnings will be invested for your future. You will contribute 4pc, your employer 3pc and 1pc comes via a Government top-up known as tax relief.
If your contributions are paid before you pay tax then you don’t need to do anything, your scheme will be getting full tax relief. This automatically increases the value of your pension before even taking into account investment growth. This is granted automatically at 20pc of the amount going into your pension.
However, if you pay your pension contributions after you pay tax, say in a self-invested personal pension (Sipp), then you will only be getting 20pc by default and need to reclaim any higher or additional rate tax, Ms Trott said.
For example, if you pay £80 into a Sipp, that will be boosted to £100 regardless of how much income tax you pay but a higher-rate taxpayer could claim back a further £20 while an additional-rate taxpayer could claim £25 extra.
This can be done via a self-assessment tax return or by calling HM Revenue & Customs and must be done every year to make sure the right amount of tax relief is given. You should do this even if you get an annual allowance charge.
You can claim any missing relief up to four years back.
When markets fall or money is tight, pension contributions can often be one of the first things to stop, but it can be advantageous to make contributions in a volatile market thanks to the effect of pound-cost average. This means that you can buy shares with the money in your pension fund at different prices, meaning you can get more for your money on average.
Tom Selby, of pension provider AJ Bell, said: “While many people will understandably be struggling to think beyond the next days and weeks at the moment, the combination of tax relief, tax-free cash from age 55 and a matched employer contribution makes pensions a difficult investment to beat.”
Michelle Gribbin, of pensions advice firm Profile Pensions, said the pandemic could force many to look for new jobs, possibly with lower salaries.
She said: “If you have been subject to a drop in income you may be tempted to opt out of a pension scheme until you’re more financially stable. But it is likely that, if you opt out, you won’t be able to rejoin at a later date.”
Your pension is essentially an extension of your pay and you would not turn down a pay rise, so consider that you may be losing out on contributions from your employer and the Government which are a valuable part of your benefit package.
Six things you can do with your pension from 55
2. Watch for the contributions ceiling
Savers have an annual allowance, which means they can pay up to £40,000 into their pensions each year with tax relief. This has steadily been eroded down from £255,000 in 2010.
This is still double the Isa allowance, but there is a tax trick you can use to boost it further, Mr Selby said.
“Pension carry forward rules allow you to use up to three years of unused allowances in the current tax year. So if you didn’t pay anything into a pension in previous tax years, you could carry forward £120,000 of unused allowances and add them to this year’s £40,000 allowance,” he said.
This can be particularly useful for anyone who is trying to make up for lost time saving for retirement.
However, anyone with an income of £200,000 or higher could see their allowance drop as low as £10,000 under the pensions “tax taper”.
3. Beware the pension freedoms tax trap
Those who are over the age of 55 and considering making a withdrawal from their pension should be aware of the tax implications.
Since 2015 the “pension freedom” rules allow savers to access their pension pot from age 55. Every year since, hundreds of thousands of savers have dipped into their pot, making use of the 25pc tax-free lump sum.
However, when you withdraw income from some types of pensions you will trigger the “money purchase annual allowance”, which means the amount you can pay in with tax relief falls from £40,000 to just £4,000.
There’s no going back from this “savage cut”, Mr Selby said, and savers lose the ability to carry forward any unused allowances from previous tax years, he warned. This measure was introduced by the Treasury to stop people recycling large sums of money through pensions to benefit from the extra tax-free cash.
“Anyone wanting to access their pension but concerned about triggering the MPAA should consider whether just taking their tax-free cash could be sufficient, particularly where they are planning a one-off purchase rather than taking a regular income,” he said.
4. Keep an eye on the lifetime allowance
Pension savers should keep tabs on the size of their pot because if a pension plan exceeds the lifetime allowance, which is currently set at £1.055m, then benefits are taxed at 55pc if it is paid out as a lump sum. If income is drawn then you will be taxed at 25pc each time you make a withdrawal.
Ms Trott said exceeding the lifetime allowance may incur a tax charge but it should not cause you to change your investment strategy. “Remember all the growth over the lifetime allowance will still be a benefit. However, you should consider when is a good time to cease contributions in order to avoid wasting your tax relief.”
Ask Kate a question | The Telegraph’s pensions doctor
5. Watch out for ’emergency’ tax codes
Over-55s cashing in on their pension for the first time to meet the income gap caused by the coronavirus pandemic risk being wrongly overtaxed thousands of pounds due to a form of "emergency" tax.
Savers were forced to claim back more than £166m during the 2019-20 tax year, with the average person being overcharged more than £3,000.
Drawing out of your pension for the first time triggers HMRC’s emergency “month one” tax on single withdrawals. When you make a large withdrawal in one month, the taxman expects that to be the monthly income across the entire year and taxes you accordingly. So someone withdrawing £10,000 is taxed as if they earn £120,000 a year.
A spokesman at insurer LV said this can happen if the pension scheme administrator does not have a tax code for the saver in that tax year. In this instance the individual would need to wait for their end of tax year reconciliation from HMRC, or proactively reclaim the overpayment of tax in a year from HMRC. “This can be a nasty shock for people who don’t have an adviser to help them,” the spokesman said.
If you have been overcharged you can get a refund sooner by filling in a "mini tax return" via one of three forms. The “P55” form is for people making only a partial cash withdrawal from their pension. Those taking an entire pension as cash must either fill in “P53Z” if they are still receiving other income, or the “P50Z” if they have stopped working.
The forms were created for pensioners wanting to claim their money back mid tax year, with HMRC promising to pay a refund out within 30 days of submitting the form.
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