Cashing in Pension Tax: Monitoring Tax-free Funds
Pension holders who are fifty-five years old and older can withdraw their pension or leave the funds invested. They can also choose a combination such as withdrawing a small percentage and leaving the remaining amount untouched, allowing those funds to continue to grow. The cashing in pension tax does not affect the first twenty-five percent of a pension, which encourages people to cash in the small sum and allow the remaining seventy-five percent to grow.
Cashing in Pension Tax Rules
Once you’re eligible to access your pension pots, your provider will request that you fill out the proper forms, noting the percentage of funds you wish to withdraw. Unfortunately, pension providers do not offer much in terms of guidance regarding how much of your funds you should withdraw or when. Should you decide to take out less than twenty-five percent you’ll need to keep track of the percentage of the amount of funds left that won’t be hit by the cashing in pension tax, as the amount left in the pot continues to grow. When it comes to tax planning, it can be difficult to withdraw your funds in the future if you fail to monitor what amount of tax-free funds are left.
For many, it can be hard to determine the right time to withdraw money, but just because twenty-five percent of the funds are tax-free does not necessarily mean you should withdraw that amount, especially if you’re in poor health. Should you pass away after you’ve drawn a large lump sum from your pension, the beneficiaries of your pension will be required to pay a large inheritance tax on top of the taxes that are associated with cashing in a pension. However, if most of your money remains in your pension at your time of death, beneficiaries will not be forced to pay an inheritance tax.
The terms uncrystallised and crystallised refers to whether or not a pension holder has removed funds from any of the pots they hold. Should you decide to withdraw a portion of your funds, the remaining funds are considered crystallised.
When you crystallise your pension seventy-five percent of the funds are taxable at the marginal rate of tax while twenty-five percent is tax-free. You’ll need to crystallise part or all of your pension in order to enjoy any tax-free cash. When crystallised money is left inside a pension, the funds are left outside of the pension holder’s estate for tax purposes. The pension holder will only be required to pay tax on these funds only when the money is withdrawn. Uncrystallised funds will still have a full twenty-five percent of funds that go untaxed upon removal.
Before removing any funds from your pots, ensure that you have a solid understanding of how much of your money will be tax-free. The best option for many is to continue to keep their money in their pots and allow it to grow until the money is really needed.
Why so Many are Cautious about Cashing in Pension Pots
People who are on a tight budget should absolutely be cautious about withdrawing money from their pensions. Withdrawing money in smaller amounts and only when absolutely necessary will minimise the amount of taxes that need to be paid. The process in which the taxes are deducted from pots can be fairly complicated.
Cashing in your Entire Pension: Trivial Commutation and Pension Flexibility
According to rules that were enforced in 2006, if a pension holder’s total amount of savings are considerably low they can withdraw the entire amount as cash. This is referred to as trivial commutation. If the funds do not exceed £30,000, these funds can be cashed in without having to purchase an annuity. As of April 2015, only final salary pension schemes are eligible for trivial commutation payments. If your occupational pension benefits are less than £10,000 these funds can be withdrawn as separate small lump sums.
The changes that occurred in April of 2015 mainly affect pension holders who have defined contribution schemes. The changes will apply to the pension holder if they have one or more pots of investments or cash in pensions. Even though tax rules now allow the withdrawal of a portion of pension funds, some pension schemes will not allow it. If you’re unsure of the rules that apply to the pension you’re paying into, speak with the pension provider.
Pros and Cons for Withdrawing a Large Lump Sum from Pension Funds
The biggest advantage to taking out a lump sum from your pension is the fact that it will be tax-free. This allows you to use the funds to pay down debts or take a holiday. The lump sum can also be invested, giving you more income during retirement. If you’re in poor health, touching your pension can make the best financial sense, but ultimately will leave fewer funds for your beneficiaries to live on should you pass.
Arguably, taking out a large lump sum can seriously impact your retirement funds. However, some people choose to use the lump sum to purchase an additional annuity, but these annuities often end up generating a smaller income than what most people expect. Before you make any retirement decisions, seek financial advice because withdrawing a lump sum from a final salary scheme can be complicated, especially if you’re not familiar with the cashing in pension tax laws.
Ultimately, whether or not a person should cash in their pension will depend on their current financial situation, their number of pension schemes and their plans for the future. For many, cashing in their pots is the best solution in order to pay down debt and live more comfortably from month to month. But poor planning and a lack of knowledge regarding taxation and other fees can cause many people to live out their retirement struggling to stay on top of bills or force some to return to the workforce. With the help of a financial advisor you can plan on the percentage of pension funds you wish to withdraw over time and monitor what portion of your pension remains untaxed, what type of tax fees you’ll be expected to pay and how your investments are performing should you decide to keep most or all of your pension funds invested.