The 2014 Budget changed the entire landscape for retirement and saving. Here's how to make sure that you are not paying more tax than you need to.
It's great that new retirees are getting more freedom to decide what to do with their pension pots.
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Remember, from April 2015, anyone over 55 will almost certainly be able to withdraw all the money from their pension pot in one go. And if you can't wait till next year, you can withdraw all the money using flexible drawdown right now, assuming you're eligible.
However, you do need to be careful. If you take all the money now, you may end up paying more tax than you need to.
Let's look at an example:
For this example, we're going to go forward a year and imagine we're in April 2015.
Sarah is 58. She's still working and is earning £35,000 a year. She owns her home outright. She'll be eligible for a full state pension when she turns 66. She has £150,000 in her pension pot and no other savings.
Now she could take her whole pot in one go immediately. However, the problem is, she'll end up paying a lot of tax. That's because if you withdraw money from your pot, it's taxed at your highest rate of income tax, apart from the tax-free lump sum.
Here's how the income tax allowances work for 2014-15:
£0 to £10,000:No income tax
£10,000 to £41,865: 20% tax
£41,865 to £160,000: 40%
£160,000 + : 45%
She won't have to pay tax on a quarter of the pension pot because that will be her 25% tax-free lump sum. That's £37,500 tax free.
But there will be plenty of tax to pay on the remaining £112,500 in her pot. If you combine that sum with her salary of £35,000, her total income for the year is £147,500, and she'll be paying 40% tax on a big chunk of that.
Indeed her total tax bill for the year would be £52,627.
But if Sarah gradually withdrew her money from her pension pot, she could reduce her tax bill considerably.
She could leave her pot alone while she continued to work. Then when she retired, she could take the tax free lump sum (£37,500). She would also have the state pension and could withdraw, say, £10,000 a year from her pension pot.
Her annual income would then be around £16,000 a year.
If she did that, she'd only have to pay a small amount of income tax each year roughly £1200. Most importantly she would never pay income tax at a higher rate than 20%.
Of course, if Sarah withdraws £10,000 a year she may empty her pot before she dies. But at least by gradually withdrawing money, she'll pay a lot less tax than if she took her money out as one lump sum.
If you take all your pot in one go, there's a good chance that you'll have to pay income tax at 40% or 45% on at least some of the pot.
The problem with annuities
The problem with annuities is that the payout rates have crashed over the last 15 years. That's unless your pension pot has a guaranteed annuity rate more on that at the end of this chapter.
There have been two main reasons for decline in payout rates. Firstly, life expectancy has grown.
Secondly, gilt yields have crashed. Annuity rates are closely linked to long-term gilt yields. As yields rise, annuity rates for new retirees go up. And vice versa.
Admittedly, annuity rates did go up last year thanks to rising gilt yields - but current rates are still at very low levels. So if you're a 65 year old in good health with a £100,000 pot, you could get a level annuity of roughly £6000 a year.
And if you wanted an index-linked annuity, you'd get roughly £4000 a year.
These rates clearly aren't great. You'd have got much more money if you'd bought your annuity in the 90s roughly twice as much or more.
Annuities are also very inflexible. Once you've bought your annuity you're stuck with it. There's no going back. You also won't benefit from any rise in the stock market.
Annuities aren't all bad though. The big attraction is they give you a guaranteed income that lasts for life.
What's more, if you have any health problems when you buy the annuity, you may be able to get a bigger payout known as an enhanced annuity'.
Even relatively minor conditions such as high blood pressure can boost your payout. The same is true if you're a smoker or heavy drinker.
Get the best possible deal
If you decide that you want the security of a lifetime income, it's essential that you get the best possible deal.
So if you have any health problems or you're a smoker, you must tell the provider during the application process. Also make sure that you shop around and get quotes from a wide range of providers.Annuity Direct and Hargreaves Lansdown are two sites where you can compare quotes.
Why do you need to do this?
These questions are important because the answers will help you to decide how to use your pension pot. If you don't really have any other assets or income, then it would probably be a dumb idea to take all the money out of your pot and blow it on fancy holidays.
On the other hand, you might realize that you could afford to spend, say, 40% of your pot, and still be confident that you could be financially secure for the rest of your life.
One more crucial point: remember that you may well live for longer than you expect. You could easily live to 90 or longer. That's a strong argument for using at least some of your pot to buy an annuity.
Or you might decide to use your pot to create your own self-managed annuity.' You could do that by investing in a combination of bonds and shares that pay a decent dividend.
The trick here is to only take a relatively modest amount from your self-managed annuity each year. Then you're much less likely to run out of your money before you die.
If you want to get some advice on how to build a balanced investment portfolio, take a look at our Lifetime Wealth newsletter here.
If you're unsure about what route to take, it is worth taking advice from a good financial adviser.
The government has also said that it plans to offer free face-to-face guidance to anyone who is about to retire with a defined contribution pension pot. We don't know yet how good the guidance will be, but heck, it's a free service, so it's probably worth taking up this option when it's up and running.
Ed has been a private investor since the mid-90s and has worked as a financial journalist since 2000. He's been employed by several investment websites including Citywire, breakingviews and The Motley Fool, where he was UK editor.
Ed mainly invests in technology shares, pharmaceuticals and smaller companies. He's also a big fan of investment trusts.
Away from work, Ed is a keen theatre goer and loves all things Canadian.
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