Weekly Update July Monday 5th 2021

Weekly Update July Monday 5th 2021

Tax-free cash: take it or leave it?

Taking 25 per cent tax-free cash from a pension is a popular perk. The option of taking 25 per cent of your pension fund tax-free is one of the most popular benefits of saving into a pension.

Many people like the idea of withdrawing this and spending it on the holiday of a lifetime, home improvements or helping children or grandchildren. However, the question should be asked: could people be better off leaving that money invested and withdrawing their tax-free cash gradually over a longer period?

It is worth thinking carefully about whether this really is the best option as this will depend much more on your personal circumstances and goals.

For example, withdrawing 25 per cent tax-free cash and putting the proceeds into a low-interest savings account could suffer a double whammy of inferior returns and, by moving the money out of a tax-efficient tax wrapper, it will be assessed for inheritance tax as part of your estate.

There is also inheritance tax, which is an important factor to consider about when and how to access pension savings. With the inheritance tax nil rate band (£325,000) and residence nil rate band (£175,000) now frozen until 6 April 2026, an increasing number of people are finding they have a potential IHT liability. Unnecessarily taking money from a pension can serve to only increase this potential IHT burden, but by leaving your money in a pension, your pension can be passed onto beneficiaries tax-free.

At retirement, too often people are presented with options that suggest they must take all their tax-free cash upfront as a ‘use it or lose it’ option. But for many people, that is not the case, and if their pension provider does not allow tax-free cash to be drawn gradually, it is worth finding one that will.

Devilish details

Here is what clients should consider.

Most retirees are able to take up to 25 per cent of their pension savings tax-free and this option is one of the most popular features of private pension saving.

As a result, few people want to miss out on taking their tax-free cash and most take their full entitlement at the point that they first access their pension.

For those taking a scheme pension or buying a lifetime annuity, they have a binary choice: either take the tax-free cash or take a higher taxable income.

However, for those looking to access their pension more flexibly, there is a third option to take the tax-free cash gradually.

For retirees who don’t need the full lump sum immediately (for example, to pay off mortgage or debts), this third option can help maximise retirement income and the inheritance available for family and friends.

Trevor, 60, is retiring with a £400,000 pension fund.

He wants to use his tax-free cash to pay for a dream holiday and home improvements, which will cost £20,000. He has finished paying his mortgage and will need an income of £2,000 a month (£24,000 a year) after tax. He will initially fund this from his pension (through drawdown) until he qualifies for a full state pension at age 67, which will then part fund the income requirement.

Scenario 1

Trevor takes his full tax free cash entitlement of £100,000. After paying for his holiday and home improvements, the remainder (£80,000) will be placed in a low interest savings account for emergencies:

This approach should allow Trevor to meet his income requirement until age 88, after which his pension fund would run out and he would become fully reliant on the state pension and other savings.

Trevor still has the remaining £80,000 of unused tax free cash (plus interest earned), which can be used to make up any future income shortfall or provide an inheritance to loved ones on death.

However, money held outside the pension will form part of Trevor’s estate – when added to his other assets, any amount exceeding the inheritance tax threshold will be subject to inheritance tax at 40 per cent.

Scenario 2

Trevor only takes £20,000 of his tax-free cash entitlement to cover the holiday and home improvements. He then uses a combination of tax-free cash and drawdown income to provide his income needs in a tax efficient manner.

This approach allows Trevor to meet his income requirement indefinitely.

In fact, the drawdown fund is projected to start increasing in value again after age 78 – this will give Trevor scope to draw additional income to take into account rising costs (from inflation) and leave a significant legacy to family and friends when he dies.

Self-employed need better retirement provision

The self-employed – and particularly younger gig economy workers – desperately need some solid pension solutions to help them make long-term provision for their retirement. Britain’s 4.8m self-employed are finding themselves in economically tough times since Covid-19 came to our shores.

Research by Quilter also reveals two “lost decades” of earnings growth, pension and other savings, which have hit the self-employed particularly hard, as Jonathan Greer, head of retirement policy at Quilter, said. This means there is more than engagement needed to get gig economy workers – including many young people who are working several jobs post-pandemic – into the savings habit and investing towards a more financially healthy retirement.

Third of millennials not saving into a pension pot

A third of millennials are not saving for their future and find pensions very confusing, according to a new study. The research conducted by Profile Pensions found that many of those who fall into the millennial age bracket of 23-38 feel uninformed about pensions. The pension provider wanted to learn more about the younger generations, and their attitudes and behaviours towards saving for retirement.

The study showed that one in four millennials find pension rules very confusing and more than half (53%) said they wished their employer would explain pensions and their benefits to them. It also showed that 23% of millennials admitted they weren’t sure if they were on target for retirement saving. More than a third (37%) believe they are saving as much as they can, yet still don’t believe it’ll be enough to retire comfortably on.

A further 16% don’t think they will ever have enough money saved to afford to retire and 28% said they lack confidence with money and financial matters. However, the number of millennials paying into a pension pot has been boosted in recent years. The introduction of the auto-enrolment scheme has almost doubled the participation of 22-29-year-olds saving into pensions, according to research by the Pensions Policy Institute.