The Retirement Podcast Cafe gives expert advice
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With many people struggling to cope with the cost of living as inflation continues to soar, some could use their pension to help bridge the gap. However, this may come with serious risks and Britons have been warned to “stop and think” before making a potentially damaging decision.
Tom Selby, head of retirement policy at AJ Bell, said: “The start of the tax year is traditionally peak pension withdrawal season, with hundreds of thousands of savers dipping into their retirement pot – many for the very first time.
Mr Selby believes this year is likely to see record numbers accessing their hard-earned pension pots.
He explained: “Spiralling inflation is already hitting household budgets and as eye-watering gas bills land at millions of Brits’ doors, it is inevitable more people will turn to their pensions to ease the immediate financial pain.
“Anyone thinking about accessing their pension for the first time or hiking withdrawals to cope with rising living costs should stop and think before making a rash decision.
“Accessing your retirement pot early or withdrawing too much, too soon could have disastrous consequences over the long-term.
“What’s more, the generous tax treatment of pensions on death means it often makes sense for your pension to be the last asset you touch.”
Mr Selby warned Britons of five key reasons to stop and think before accessing their pension pot early or increasing withdrawals during the cost of living crisis.
Early access increases the risk of running out of money in retirement
He said: “Pensions can now be accessed flexibly from age 55 – but for most people the aim of the game remains providing an income to support their lifestyle throughout retirement.
“Withdrawing too much, too soon from your fund means you’ll increase the risk of running out of money early – and potentially being left relying on the state pension.
“In 2022/23, the full flat-rate state pension will pay just £185.15 per week, a long way below the spending needs of most people.
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“Take a healthy 55-year-old with a £100,000 pension pot. If they withdraw £5,000 a year, increasing annually in line with inflation at two percent, and enjoy four percent annual investment growth their fund could run out by age 80.”
Mr Selby explained that the average life expectancy for a healthy 55-year-old is in the mid-80s, with many having a decent chance of living well into their 90s.
He therefore believes increased withdrawals would create a “serious risk” of people draining their pot early.
“Put simply, if you raid your pension pot early, you’ll either need to keep your withdrawals very low – potentially harming your quality of life later in retirement – or face up to the prospect of your pot running out sooner than planned,” he added.
Early access could see savers miss out on investment growth
Mr Selby continued: “The sustainability problems created by taking an income early from your pension will be compounded if you miss out on investment growth at the same time.
“While savers have total freedom over how to invest their retirement fund, it usually makes sense to take a bit less risk when you start taking an income from your pot.
“At the very least you will need to sell some of your investments to make a withdrawal, meaning you might have somewhere between 12-24 months of income held in cash. This lower risk portfolio will inevitably have lower return expectations over the long-term.”
It could trigger a 90 percent annual allowance cut
Anyone considering withdrawing taxable income from their retirement pot for the first time should consider the impact it could have on their ability to save tax efficiently in a pension in the future.
Mr Selby explained: “Taking even £1 of taxable income from your pension flexibly will trigger the money purchase annual allowance (MPAA), potentially reducing the amount you can save in a pension each year from £40,000 to just £4,000.
“Furthermore, if you trigger the MPAA you will lose the ability to ‘carry forward’ unused pensions allowances from up to three previous tax years, meaning in some cases the impact will be a £156,000 reduction in the potential annual allowance in the current tax year, from £160,000 to £4,000.
“If you are struggling to make ends meet and your pension is the only asset available to support you, consider just taking your tax-free cash (or a portion of your tax-free cash) as this won’t trigger the MPAA.
“Alternatively, it is also possible to access up to three defined contribution (DC) pots worth £10,000 or less without triggering the MPAA, provided you exhaust the entire pot in one go.”
Hiking withdrawals risk hurting sustainability
Mr Selby said: “Most people will want their pension withdrawals to increase in line with inflation in order to maintain their living standards. However, if inflation runs hot for an extended period of time, this will have a big impact on the sustainability of a withdrawal plan.”
To demonstrate the impact of inflation, Mr Selby used the example of a healthy 66-year-old, who has a fund of £100,000 and wants to withdraw £5,000 a year from their pension, rising in line with inflation.
He calculated that if inflation is two percent a year throughout their retirement, their fund could last until age 91, whereas if inflation is four percent a year, the fund could run out by age 85 – a full six years earlier.
“Inflation is unfortunately entirely out of our control. However, anyone planning to increase their withdrawals to maintain their spending power during the current period of high inflation should think about the impact on the sustainability of their plan.
He also warned that the rate of inflation is only an average mark based on a weighted basket of goods, and people’s individual inflation may be higher or lower depending on their circumstances.
Don’t forget about inheritance tax
Since 2016, Britons have been able to pass on their pensions tax-free if they die before age 75.
Where the pension holder dies after age 75, the remaining funds will be taxed at the marginal rate of the person who receives the pension when they make a withdrawal.
Mr Selby concluded: “For those who want to leave assets to loved ones, it therefore often makes sense to leave as much of your pension untouched as possible in order to minimise your tax bill.
“This means when you come to flexibly access your pension for the first time, you should think not just of your retirement income strategy but also your IHT plans. If you have money held in an ISA, for example, this will count towards your estate on death.
“For those who want to pass their pension on to loved ones, it’s also important to ensure your nominated beneficiaries are up-to-date so the right people inherit your pot.”
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