Pensions
How you decide to withdraw from your pension dictates how much of your money goes to the tax man.
You have options...
- Keep your pension invested whilst drawing an income. This is known as income drawdown, where part of your pension is invested and part is taken as income. You can withdraw up to 25% of your pension pot tax-free (not necessarily in one go), with the remainder taxed at your marginal income tax rate. The decision on how much to withdraw and when is entirely up to you. If preferred, a regular income can be set up. Its duration will depend on the performance of your investments and the amount you withdraw.
- Purchase an annuity. You could take the first 25% of your pension pot tax-free and use the rest to buy an annuity - the income you get from the annuity is taxed as earnings. Annuities effectively give you a guaranteed income for life – a set amount every month until you die - no matter how long you live.
- Take your pension in one go. You could cash in your entire pot – 25% is tax-free, and the rest is taxable. However, cashing in your entire pension at once could push you into a higher tax bracket, leading to a larger tax bill. Not to mention, this approach might risk depleting your funds prematurely, leaving you underfunded in later retirement years.
- Mix your options. You don’t have to choose just one of these options, you can choose to mix different options. This can give you flexibility to suit different needs at different times during your retirement.
- Pass your untouched pension down to your children. If you can afford it, and you have other ways to fund your retirement, it may be best not to withdraw from your pension. Pensions can be a tax-efficient way of passing down your wealth to your children because they aren't part of your taxable estate, so inheritance tax doesn't usually apply.
If you die before the age of 75, your beneficiaries will normally inherit your pension pot tax-free. However, if you die after the age of 75, then your beneficiaries will pay income tax on anything they withdraw from your pension savings.
Remember, making the most out of your money in retirement isn’t just about how much you have, but also how you choose to take it. The sequence in which you choose to draw on your assets can have significant tax benefits by keeping you within lower tax bands for as long as possible.
UK State Pension
Background:
- In the UK, you need at least ten years of NI contributions to qualify for the State Pension. A complete record of 35 years maximises the entitlement.
- Until 5 April 2025, you can compensate for any shortfalls in your NI contributions all the way back to 2006.
- Voluntary Class 3 NI Contributions can be purchased to fill the gaps in your NI record.
- For example, it would cost £8,273 to top up the most recent 10 missing years, resulting in an extra £3,026 per year, or £60,528 over 20 years of retirement (before inflation).
- Voluntary Class 3 contributions currently cost £17.45 per week. If you want to fill gaps for the last two tax years, you can pay the cost applicable during those years.
- You may be able to top up any missing years free of charge in certain circumstances.
- You can check your NI contributions online, and it's worth checking your State Pension forecast as well.