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Tax risks of accessing pension pot to cope with Covid-19

30 April 2020

Over one in ten pension savers (11%) aged 55 plus have either accessed or plan to access their retirement pot earlier than anticipated to cope with the effects of Covid-19, new research has revealed.

Retirement specialist AJ Bell warned that individuals planning on dipping into their pension need to understand the tax implications of doing so. 

Withdrawals risk triggering the money purchase annual allowance, reducing the amount most people can save in a pension each year from £40,000 to £4,000.

In addition, pension savers who plan to take a regular income early should consider the sustainability of their withdrawal plan as sharp drops in the market affect the value of funds.

As an example, AJ Bell said someone taking a 5% inflation-adjusted income who experiences a 20% drop in the value of their fund in the first year of drawdown could see their savings run out after 18 years.

According to AJ Bell, over-55s should think about the current market fluctuations before choosing a retirement income route.

Senior analyst Tom Selby explained: “Hundreds of thousands of savers access their pension for the first time every year, with the majority of those entering drawdown citing getting their 25% tax-free cash as the main reason for doing so.

“If you choose drawdown, then once you have taken 25% of your fund as tax-free cash, the remaining drawdown fund continues to benefit from any investment growth. However, if you crystallise your entire fund you have taken all the tax-free cash you can from that fund – you can’t go back and take more if the drawdown fund grows.

“With the FTSE100 down over 20% since the start of the year, millions of people with pensions will have seen the value of their funds plummet. Anyone choosing to access their tax-free cash today risks ‘selling on the dip.’”

Selby said individuals who need to access some tax-free cash earlier than planned as a result of Covid-19 should consider partial crystallisation as a way to mitigate the impact on the overall tax-free cash entitlement.

Selby said: “If someone with a £100,000 fund wanted to access just £10,000 tax-free cash, they could choose to crystallise £40,000 of their fund rather than the entire amount, giving them the £10,000 tax-free cash they need.

“The remaining £30,000 drawdown fund and the £60,000 ‘uncrystallised’ part of the fund – including the remaining tax-free cash entitlement – would have the opportunity to grow over time.”

Savers can also opt to take an ad hoc lump sum from their pension fund, with 25% of each withdrawal tax-free.

Although there is no going back once someone has crystallised their pension,  the good news is that they can continue to make contributions and build up tax-free cash entitlement on those contributions.

Selby said: “If someone with a £100,000 fund accessed all their available tax-free cash at age 55 but then continued saving £3,000 a year into a pension, their new contributions could deliver a fund worth £47,000 by age 66, including a tax-free cash entitlement of £11,750.”

Selby said savers should use this opportunity to review retirement plans, goals and how their investments will help them achieve this.

Selby added: “While many will understandably be spooked at the idea of investing at the moment, it is worth remembering that short-term volatility has historically been the price you pay to enjoy longer-term growth.

“Investors also need to be aware of and comfortable with the risks they are taking. Although investments can go down in value as well as up, as we have seen in dramatic circumstances recently, the value of any investments left in cash will be eaten away by inflation over time.”

 

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