The new rules will mean that for most of us, it will no longer be necessary to buy an annuity when we reach pension age. One of the main alternatives, drawdown, involves leaving most or all or a pension invested in the stock market or other assets, and taking a regular income from it.
But the new system is designed to encourage individuals to take full responsibility for how they use their lifetime savings to provide for their old age – and this includes giving them the option to take their pensions as cash if they wish.
Politicians hope that most people will use this money wisely, for example to make other non-pension investments such as buy-to-let property.
But there are no restrictions on how the money can or should be spent. Shortly after the reforms were announced last spring, pensions minister Steve Webb pointed out: “If people do buy a Lamborghini but know that they’ll end up just living on the state pension, that becomes their choice.”
While using your hard-earned pension to buy an expensive Italian sports car might not be the most sensible move, the government no longer thinks it is necessary to protect savers from themselves.
How the pension rules are changing
Under the pre-April 2015 system, anyone aged 55 or older can take a quarter of their pensions as a tax-free cash lump sum if they wish. This is not changing.
But under the old regime, any further withdrawals are classed as “unauthorised payments” by the authorities and taxed at an eye-watering 55 per cent.
The reforms mean this 55 per cent rate is being abolished and replaced with income tax at the individual’s marginal rate – which could be 0 per cent, 20 per cent, 40 per cent or 45 per cent for the highest earners. (This lower-tax rule already applies if your total pension savings are worth £30,000 or less.)
The rate that applies to you will depend on what other income you earn in that particular financial year, and how much money you are taking out of your pension. And bear in mind you can make several smaller withdrawals over a period of years: you don’t have to take the whole pension at once.
If you make smaller withdrawals like this, a quarter of each will be tax-free with the remainder taxed as income.
Minimise your tax bill
Say for example you had a pension fund of £100,000 and you decided to take it all in cash. Under the old system, £25,000 would be tax free but the remaining £75,000 would be taxed at 55 per cent: this means a tax bill of £41,250 leaving you with just £58,750.
Under the new system, assuming you had no other income during that tax year and weren’t yet receiving the state pension, the tax on the £75,000 would probably be less than £20,000, leaving you with £80,000.
By taking such a large amount, however, some of your money will be taxed at the higher rate of 40 per cent. If your annual income is no more than £42,000, you will only pay the basic rate of 20 per cent.
The advantage of making several smaller withdrawals over a number of years is that it can help keep your tax bills down by ensuring you don’t go into the higher-rate tax band.
Why take your pension as a cash lump sum?
Assuming you haven’t put your name down for a Lamborghini, what are the reasons for taking your pension as cash?
If you only have a small amount saved up, there may seem little point in buying an annuity or putting the money into drawdown.
A pension of £40,000 would buy a typical 65-year-old man an annuity income of little over £2,000 a year. Women would get less because of their higher life expectancy. In this case, taking the cash could seem a more attractive option.
If your pension is relatively small, you may find that the charges related to leaving it invested in a drawdown scheme make this route uneconomical.
But even for those with larger funds, taking pension as cash can make sense.
For example, this would mean you were able to put money into savings accounts or cash Isas.
Another alternative is peer-to-peer lending through platforms such as Zopa and FundingCircle: these services let individuals lend money to consumers and businesses to generate a higher rate of return than is available on deposit accounts, although they do carry a greater level of risk.
Putting money directly into shares or investment funds is another option, although this would also be possible through drawdown.
Many people approaching retirement are considering using their pension cash to invest directly in property: as a landlord, you could get a regular income from tenants, as well as benefit – hopefully – from rising house prices.
You could also consider investments outside the mainstream, such as fine wine, art or classic cars – but bear in mind these are likely to carry a much higher level of risk. A further problem is that it can also be difficult to cash in investments such as these quickly if you need your money back for any reason.
Many pensions experts expect to see savers use a variety of options when it comes to turning their funds into income for their retirement. Part of your pension could be used to buy an annuity, with some going into drawdown and the remainder being taken as cash.
Bear in mind that even if you opt for an annuity or drawdown, you will still be able to take 25 per cent of the overall fund as a tax-free cash lump sum if you wish.