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The Right Way to Cash in Pensions

Richard Beardsworth Pension Expert

By Richard Beardsworth.

Independent Financial Advisor

More Reading on Cashing In Pensions...

In order to cash in a pension the right way, one must understand the rules that govern the process. For example, there are specific age requirements dictating when pension payments are authorised and when they are not. Most people who get into trouble do so because they have agreed to some sort of scheme for cashing in a pension early. Had they known the rules, they could have avoided the problems.

Explaining the rules is a good place to start in addressing the right way to cash in pensions. We will begin by talking about the established age restrictions.

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Early Withdrawals

The Government has established age 55 as the starting age at which you can cash in a pension without incurring any penalties. There are some exceptions. For example, people suffering from extremely poor health limiting life expectancy or requiring them to retire early may have access to their pension funds prior to age 55 as long as they meet certain eligibility requirements.

Can you cash in a pension early, outside of one of these exceptions? Only if you are willing to pay the penalty. However, you need to understand that the penalty is significant. Right now, it stands at 55% of the total amount of unauthorised payments you receive. If you take just £1,000 out of a pension scheme as an unauthorised payment, your tax bill would be £550. If you completely drained a £30,000 pension, you would pay £16,500 in penalties.

The first rule of thumb for cashing in your pension is to not do it early unless you meet one of the exceptions. Otherwise, the combination of the government penalties and the charges assessed by your pension administrator could take most of what you have, if not all of it.

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Consider Your Pension Value

Let us assume you are already 55 or older. You are in a position of taking your pension funds without incurring any penalties. Your first step is to determine what the value of your pension is. If you have multiple pensions, you need to find out what all of them are worth. You might also consider searching for lost pensions if you have reason to believe you may have some out there.

Knowing the value of all of your pension schemes tells you right up front how much money you have to work with. Why is this important? You are considering cashing in because you want to do something else with the money, right? There is no way to know whether your plans are viable or not without knowing how much money is available to you.

Finding out the value of your pension is as easy as contacting your pension administrator. Upon request, the pension administrator will issue you a statement detailing the value of your pot on the day of your request. This is important because that value will fluctuate depending on how your investments are doing. The value may be higher next week if your investments are doing well. Conversely, poor performing investments may mean it's worth less next week.

Uncrystallised Funds Pension Lump Sum (UFPLS) – withdrawal of entire fund

What is it?

You can withdraw a single lump sum from your pension without the need to move the funds into a drawdown plan first. 25% of the fund may be taken tax free with the balance taxed at your marginal rate(s) of income tax.

Eligibility

In order to take advantage of UFPLS there are a number of conditions that need to be met:

  • You must be aged 55 or over or, if younger, meet ill-health conditions.
  • The payment must be payable from your uncrystallised rights held in a money purchase pension.
  • If you are aged under 75, you must have more lifetime allowance remaining than the lump sum required.
  • If aged over 75, you must have some lifetime allowance remaining.
  • If you have primary or enhanced protection with protected tax free cash or a lifetime allowance enhancement factor but the lump sum allowance is less than 25% you can’t take your benefits as a UFPLS.
  • Where scheme specific lump sum protection exists, the right to the higher TFC would have to be given up in order to use UFPLS.

Main Features of UFPLS

Age and Health

You can choose how much you want to withdraw without reference to any rates or limits other than the size of your pension fund.

If you or your spouse is relatively young, a secured pension (lifetime annuity or scheme pension) would be less attractive due to the lower mortality factor.

Investment Risk

The value of any uncrystallised segments may go down as well as up and investment returns may be less than those shown in the illustrations.

This could result in a lower income if/when an annuity is eventually purchased.

Other Risks

Annuity rates may be at a lower level when annuity purchase takes place and there is no guarantee that your income will be as high as that offered under the other options referred to earlier.

There is no guarantee that annuity rates will improve in the future.  They could be lower if/when you decide to purchase an annuity than they are currently.  Your pension may be lower than if you bought a lifetime annuity now.

Flexibility

You can take all of your pension fund as a lump sum or take your fund in stages over a number of years.

An annuity or drawdown pension can be purchased with any of the funds you withdraw (or you can utilise the funds in any way you see fit). 

You can elect to take any uncrystallised pension funds in other formats such as annuity purchase or flexi-access drawdown. 

Your uncrystallised pension funds continue to be invested, thus providing you with the possibility of higher future income. This depends largely on how much you take out of the pension fund and future investment returns achieved on the residual fund.

You will be able to change the shape of your retirement income to reflect your personal circumstances in the future. Should your health deteriorate, it may be possible to achieve a better annuity rate (ie. higher income) in future. It is also possible to postpone the choice of whether to include any survivor’s pensions until a lifetime annuity is purchased – this could be valuable for someone whose spouse is in poor health.

Taxation

You will receive the first 25% of all withdrawals tax free and the remainder will be taxed at your marginal rate(s) of tax.

You will not receive all of your tax free cash as a lump sum at outset, if you are accessing your pension fund gradually over time and using the cash to supplement your income.

The provider of your pension planwill make your payment through the PAYE system and you should be aware that if they do not hold your correct tax code, an emergency code will be used and you may need to reclaim or pay additional tax through your self-assessment tax return or by way of a separate claim.  

You can structure your income to mitigate liability to personal income tax.  By reducing your withdrawal in some years you may be able to avoid a higher rate tax liability.

Transfers & Withdrawals

The first 25% of any lump sum is tax free and you will be taxed at your marginal rate(s) on the remainder. 

You can take all or part of your pension fund at any time.

Benefits may commence at any time from the age of 55. From 6 April 2011 rules were introduced such that anyone with a defined contribution pension arrangement (not final salary) who had not, before that date, taken a pension, could postpone the decision to take benefits from their scheme indefinitely (the previous requirement was that an income had to be secured by age 75 at the latest).

Availability

Some products will not be able to support UFPLS and you may need to transfer your pension fund before being able to withdraw your funds. 

Long term care

Any uncrystallised segments will be taken into consideration on the basis of the annuity income they could provide should you require long term care in the future. If you have withdrawn all of your pension fund and it is in a bank account or other savings vehicle it may also be taken into account.  

Treatment after death

Any pension funds that are still uncrystallised on your death (ie. remain in your pension plan untouched) can be paid to your beneficiaries as a lump sum, used to provide an annuity income or moved into drawdown to be drawn on as and when required. Funds withdrawn as a lump sum or as annuity or drawdown income will be tax free if you died before age 75. On death after age 75, both lump sum and income payments (annuity or drawdown) are taxed on the recipients at their marginal tax rate(s).

If you take the UFPLS and do not spend it, it will be included in your estate and be assessable for inheritance tax.

Type of charges

There may be ongoing charges for any uncrystallised segments.

Future planning issues

If your health/circumstances change, you can move any uncrystallised segments into drawdown and or/purchase an annuity.

Further tax-relievable pension contributions may be made before age 75. Where an UFPLS payment has been taken, tax relievable contributions to money purchase pensions will be limited to the £10,000 money purchase annual allowance rather than the standard annual allowance of £40,000.

When you first flexibly access your pension, the scheme administrator has to provide a statement to you within 31 days. You must then notify any other schemes that you are an active member of (i.e. where contributions are being paid to a money purchase scheme or you are accruing benefits under a cash balance or hybrid scheme) within 91 days of receiving their statement, so that they're also aware that the £10,000 money purchase annual allowance will apply.

 

Consider Your Options

The next step in cashing in a pension the right way is to consider your options for the cash you are about to get. Let us assume you plan to invest the money in something that will provide a better return. Where will it be invested? You might be considering splitting up the money between stocks, bonds, and precious metals. Perhaps you plan to invest in a private equity fund focusing on technology businesses in Eastern Europe. On the other hand, maybe you are seriously looking at the opportunity to invest in rental property. All of these options need to be considered in light of the total amount of money you have to work with.

Maybe you want to cash in your pension not for investment purposes, but simply to use as regular monthly income. If so, cashing in may not be your best option. You might be better off leaving the money alone and electing for a drawdown contract instead. A drawdown contract will allow the money remaining in your pot to continue earning even as you drawdown. This is a more profitable way to use a pension pot as monthly income.

Consider the Costs

When it actually comes time to cash in your pension, understand that it comes with associated costs. As the Money Advice Service explains, pension schemes are known to charge fees whenever clients leave their plans. This is true whether you are cashing in or simply transferring from one plan to another. These charges are assessed in order to cover the expenses of the administrator and make up for some of the losses they will incur as a result of you pulling your money out.

Most of the time these charges will be minimal. Nevertheless, they can be quite significant, especially if they are tied to the value of your pension pot. In cases in which fees and charges eat up a significant portion of what you have saved, you might be better off leaving the money alone and allowing it to grow a bit more cashing it in.

Get Sound Advice

Lastly, it is impossible to talk about the right way to cash in a pension without mentioning the need to get sound advice. The advice you need covers multiple topics depending on your reasons for cashing in and what you intend to do with the money. Getting advice is part of doing your due diligence; it is part of protecting your best interests.

In a general sense, a certified financial advisor can help you understand the various investment options you have in front of you. The advisor can explain stocks and shares, annuities, savings accounts, bonds, etc. Be aware that rule changes as a result of the financial overhaul a few years ago require financial advisors to make sure clients are given every opportunity to take advantage of the best choices for their money. Your financial advisor might offer to sell you specific products or services in order to meet this requirement.

Having said all that, we advise that you do not settle for any certified financial advisor in general. Rather, seek out an advisor who specialises in pensions. It is no secret that pension law is complex in every aspect. A financial advisor who specialises in the stock market may not know all the minute details of pension investing. You want someone who does.

There is a right and wrong way to cash in a pension. The right way starts with understanding the rules as they relate to your age and unauthorised payments. From there it is a matter of knowing your pension value, considering your options, considering the costs involved, and getting sound advice. By doing things the right way you will be maximising the potential of your savings to meet whatever financial goals you have.

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