Martin Lewis warns of a tax lure that might value you £10,000s off your pension

Taking money out of your pension can be taxing

Martin explained that there are a couple of ways to withdraw money from your pension pot – but one method is likely to see you charged much more in tax. He used his Swiss roll versus a cake, plus a pot of jam, analogy to help people understand: 

  • Withdraw cash lump sums from your pension (not as tax-efficient): Martin said: “You can leave your money invested in your pension pot, then when you take it out, a quarter of it is tax-free and three quarters is taxed at your marginal rate – in other words the highest rate of income tax you’re paying at that time.

    “Here’s the issue, if you take your money out of your pension, whether you take it all or you take it in bits, you can’t say I want the 25% tax-free now and I’ll take the rest later. I use a Swiss roll as an analogy, you can have a slice and the jam is tax-free – a quarter of it is tax free – but three quarters of it is taxed, and you have to have both.

    “Now the problem with that is, let’s say you’re taking £20,000 out and you’re a basic rate taxpayer, the three quarters of that, that gets taxed and gets added on top (of any other income you earn, which) could push you into the higher rate tax bracket so you’re paying thousands you need not do.” 

  • Opt for pension drawdown (likely to be more tax efficient): But Martin explained “there is an alternative route”. He said: “You can take your whole 25% tax-free lump sum if you put the rest in income drawdown, which is an investment product you can take money out of when you need to, or an annuity, which pays you a set income each year for the rest of your life.

    “Now the reason this is important is it splits up the tax-free – the jam – from the sponge that’s taxed. I’m pushing the analogy but go with me. This is the reason that counts. Let’s say you’re a higher rate taxpayer now, if you use the Swiss roll system and take the money out you’d be paying 40% tax on all the taxed amount, but later on in your life you might drop to being a basic rate taxpayer as you’re earning less.

    “So using the alternative route you take the 25% now and you wait to take the taxed amount until you’re a lower rate tax payer, so it’s more tax efficient – you’re paying less tax on the sponge.”

See our Pension Need-to-Knows guide for further help on pension saving. It’s worth pointing out that Martin’s show was all about private pensions, which are separate to the state pension. See our State Pension guide for more on how this scheme works.  

Consider how long you’ll live before withdrawing any pension cash

Of course, despite ‘pension freedom’ rules meaning savers can now access their cash from age 55, Martin warned that you need to try and estimate how much longer you’re likely to live for as this will help you to know how much cash you need. 

Martin explained: “When ‘pension freedom’ first happened, the big newspaper worry was ‘people are going to buy Ferraris and have no money for the rest of their life’. My concern was actually the opposite. I think we’re quite risk averse as a nation, so people would be living very low standards of living so they’re eking out enough cash for the rest of their life, when they could actually have a better life.”

In order to try and find a balance, you’ll need to consider your health, genetics, whether you smoke and your current age. Martin points out that for someone aged 65 now, if they’re a man, they’ll live on average for 20 more years, and if they’re a woman, it’ll be 22 more years – so plan your finances that way and do not underestimate how much longer you’re likely to live.

You can get free help if you’re unsure of your options

If you simply want to discuss you general pension options, and get a better understanding of how your pension works and what you can do with it, you can get free guidance from the Government’s Pensions Advisory Service. 

If your pension is more complicated or you want more tailored info based on your personal situation you may want to consider seeking independent financial advice. Read our guide on Picking and Paying for an IFA. 

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