Money expert Martin Lewis is urging people to avoid a £22,500 pensions tax charge by accidentally triggering a tax bill when they spend their savings.
Martin has this week turned his attention to pensions, taking advice from specialists about how and when to draw down or spend your workplace or private pensions (ie not the state pension) without penalty.
One such issue Martin advised his followers on relates to taking money out of your pension while still paying into it.
Workers can legally access their pensions when they reach 55 years old, but many will still continue working past that date and well into their 60s.
It might be that you want to access some of your pensions savings for a project, such as buying a rental property or clearing off your mortgage balance.
But there can be drawbacks which could leave you facing a huge tax bill, Martin warned, thanks to a quirk in how the Personal Allowance system works.
Gov.UK explains: “Your annual allowance is the most you can save in your pension pots in a tax year (6 April to 5 April) before you have to pay tax.
“You’ll only pay tax if you go above the annual allowance. This is £60,000 this tax year.
“Your annual allowance applies to all of your private pensions, if you have more than one. “This includes the total amount paid in to a defined contribution scheme in a tax year by you or anyone else (for example, your employer), and/or any increase in a defined benefit scheme in a tax year.”
Martin Lewis told his listeners about a scenario in which they wanted to access up to 25 percent of their pension pot.
The 25 percent number is the maximum amount you can access as a lump sum before paying tax on what you withdraw.
But, there’s another tax trap waiting for you: if you access the funds while you’re still paying into the pot, you might accidentally reduce your pensions allowance for the year, risking a tax bill on your pension.
Martin said: “My thought was for example someone who doesn’t need the money might decide they want to take 25 percent out in order to buy a property to rent out which is not something you can do within your pension, you can invest in property in your pension but you it have to be in a pension fund. Now one of the issues is if you take money out of your pension, you can reduce the Annual Allowance, the amount you’re allowed to contribute to your pension in future.”
Martin was told: “If you take just the 25 percent lump sum, and you have zero income, that’s the tax-free amount, then there’ll be no impact to your annual allowance.
“If you start taking income on top of the tax free cash, from your pension, that could be draw-down or an annuity, whichever method, then your annual allowance will drop down. To £10,000 from a maximum of £60,000 at the moment.”
Martin added: “Despite your earnings you’re putting in. So that’s really something to be aware of. If you’re going to start taking money out of your pension but you might want to contribute to your pension in future, that’s the big nodal point where you’ve changed the status of your pension and you’ve reduced the amount you can contribute.”
If you were to lose £50,000 of your tax free pension allowance, you’d suddenly be looking at a tax bill of £10,000 on 50k for a basic rate taxpayer. If you’re a higher rate taxpayer, that’s £20,000, and an additional rate taxpayer pays £22,5000.
If you’re lucky enough to earn over £200,000 a year, that tax bill might be even higher as you will have a reduced or ‘tapered’ allowance.
