Why cashing in a pension pot as Covid bites should be a last resort
As the pandemic continues to cause financial strain across the country, some people are taking a drastic step to shore up their finances by dipping into their pension pot.
HM Revenue and Customs reported that 347,000 people withdrew money between July and September, a notable rise compared with last year. With businesses now shuttered during the second lockdown, the prospect of further high numbers of withdrawals is possible.
The shackles came off British pensions in April 2015. Reforms introduced by the then chancellor, George Osborne, got rid of the requirement to convert a pension pot into an annuity, meaning that people could do what they wanted with their retirement money once they reached 55. They could cash in some, or all, of it.
The changes immediately resulted in a collapse in the sale of annuities – which guarantee an income for life – and many used the money to pay off their mortgage. However, the pandemic is the first time that Britain has faced a financial crisis since the freedoms were introduced.
“Money may have been withdrawn to offset falls in income. Covid has, and will continue to, change lives and, in some cases, trigger early retirement or a decision to access funds early,” says Laura Stewart-Smith, workplace savings manager at Aviva. “The extension of the furlough system to March 2021 will help a lot of people, but there is still a proportion of the population who will be suffering financially.”
Rebecca O’Connor, head of pensions and savings at Interactive Investor, a share- and fund-dealing platform, says it makes sense to assume that “in hard times, when jobs and incomes are suffering, debt is high and savings are being run down rapidly, there is greater pressure to dip into this money”.
She adds: “It’s a case of immediate needs becoming so great that future ones must be sacrificed. And it’s a warning that a poor economy can result in significant pressure on pension pots.”
Besides solving an immediate financial problem, there are few benefits to withdrawing from your fund early – and a large number of drawbacks.
It’s a taxing move
Taking money out of a pot early has immediate tax implications. You can take 25% tax-free, but the rest will be taxed as your income for the year. It will be added to any other earnings and could push you into a higher tax bracket.
“If an individual were to draw large sums, particularly if they are still working, they may find they pay tax at 20%, 40% and possibly 45% on these withdrawals,” says Jonathan Watts-Lay of Wealth At Work, a financial advice firm.
The taxman also frequently applies an emergency tax to withdrawals. If you are not subject to tax you will be charged, and then need to claim the money back, says former pensions minister Steve Webb, who now works for pension consultants LCP.
“It happens to tens of thousands of people each year. This is important if you are budgeting and need an exact amount in your bank account,” he says.
Taking money out early may affect tax reliefs on future contributions. At present, you can pay up to £40,000, or all of your salary, into a pension and get tax relief on the contributions – this is known as your annual allowance. But if you withdraw more than 25%, the tax relief reduces.
If you take too much, your annual allowance is replaced by the “money purchase annual allowance”, which is just £4,000. “If you want to avoid triggering the MPAA, you could just take your 25% tax-free cash,” says Tom Selby from AJ Bell, an investment platform. “It is only taxable withdrawals which result in an annual allowance cut.”
With a reduced allowance, rebuilding your pot will be more difficult – and that problem will be aggravated by the fact that you will not have as long for the money to grow.
“This is because the power of compound growth works best when money is invested over longer periods, with relatively small, regular contributions hopefully growing to become a significant retirement pot,” says Selby. “If you are having to start from scratch (or you drained a substantial portion of your fund) in your 50s, you will probably have to make significant annual contributions to get back to where you were.”
Taking pension cash can also have knock-on effects on other benefits. “Taking out a lump sum that takes your annual income over £50,000 in a year can also mean you have to pay back child benefit, through the high income child benefit charge,” says O’Connor. “Universal credit, pension credit and council tax reductions might all also be affected.”
Beware of fraud
Financial scams are on the rise and older people are among the most vulnerable, especially those who have just taken money from their pension. With many facing financial uncertainty as a result of the pandemic, they are especially susceptible to scammers who target them with fake investment schemes.
Ed Monk of investment managers Fidelity International says there are several schemes criminals use to part people from their cash. “They might ask victims to transfer their pension pot into either nonexistent or non-genuine schemes. Or, offer cash incentives to gain early access to their pension benefits – referring to them as a ‘pension loan’, leaving the pension holder with significant losses and serious tax implications.”
Take a step back
Withdrawing money to resolve immediate problems is itself beset with problems, so think long and hard before doing it – crucially, will you have enough to last throughout your retirement?
“Most people live longer than they expect, which means that they could be facing an income shortfall at retirement if they don’t plan properly,” says Watts-Lay.
The Institute for Fiscal Studies found that those in their 50s and 60s underestimate their chances of survival to 75 by about 20%, and to 85 by around 5% to 10%. For example, men interviewed at 65 believed they had just a 65% chance of reaching 75, but the official estimate is 83%.
Webb says that if withdrawing early means you will keep a roof over your head, it may be the best strategy, but it is a decision which should not to be taken lightly.
“Money you take because of financial pressures in your late 50s isn’t available to support you through a retirement that could take you into your 80s or beyond, so it should be viewed as a last resort,” he says.
