Dipping into your pension during the current cost of living crisis can seem a tempting option if you need a cash boost, but it’s vital to think about the longer-term impact this could have.
The amount withdrawn as flexible payments from pensions between April and June 2022 stood at £3.6 billion, according to latest government data, a 23% increase compared to the same period last year. Around 508,000 individuals took money out of their pensions during this period, and the average taxable withdrawal was £7,000.
Soaring household bills are expected to prompt many more people to take money out of their pensions earlier than they might have originally planned, to help them cover steeper mortgage or rent costs, or high energy, food and petrol bills.
Here, we look at some of the things you’ll need to consider if you’re thinking about taking money out of your retirement savings earlier than you might have originally planned.
What are the rules?
Pension freedom rules introduced in 2015 mean you can usually take some or all of your whole pension out once you reach the age of 55 if you want to. There’s a 10-year gap between pension freedom age and the State Pension age, so the age at which you can access your retirement savings is due to rise to 57 when the State Pension age reaches 67 in 2028. Bear in mind different pension schemes can have different rules, so you’ll need to check with your provider to see at what age you can start taking your retirement benefits.
When you take money out of your pension, the first 25% is tax-free, whereas the rest counts as taxable income.
These rules only apply if you have a defined contribution pension, sometimes known as a money purchase pension, where the amount you’ll receive at retirement depends on how much you (and your employer if it’s a company scheme) have paid in, and your investment returns. Learn more about how defined contribution schemes work in our article What is a defined contribution pension?
They don’t apply to defined benefit or final salary pensions, which provide you with a retirement income that is equivalent to a proportion of your final salary. If you have a final salary pension and are considering transferring it, to access some of the cash built up in it, this is very rarely the right decision. You can read more in our guides What is a defined benefit pension? and Should I transfer my final salary pension.
Things to consider
If you have a defined contribution pension and you’re planning to take money out to help make ends meet, there are several things to think about first.
Taking money out of your pension could affect your entitlement to means-tested benefits
Any money you take out of your pension pot will be taken into account if you’re being assessed for benefits and you haven’t yet reached State Pension age.
For example, if you need to apply for Universal Credit, but have taken money out of your pension which means you now have £16,000 or more in savings, you won’t be eligible to claim it.
If you have savings or capital between £6,000 and £16,000, the first £6,000 is ignored. The remainder is treated as if it provides you with a monthly income of £4.35 for each £250 or part of £250.
- You have £8,000 which you’ve taken out of your pension and put into a savings account
- The first £6,000 of this is ignored
- The remaining £2,000 is counted as giving you a monthly income of £34.80
- £2,000 divided by £250 = 8
- 8 x £4.35 = £34.80
- £34.80 will be taken off your monthly Universal Credit payment.
Only savings worth £6,000 or less (£10,000 if you are over State Pension age) will not affect your claim for means-tested benefits.
Find out more about how accessing your pension and other lump sum payments can affect your benefits.
You could land yourself with an unexpected tax bill
If you do take money out of your pension, you don’t have to pay any tax on the first 25% of this, but the remainder would be taxed at your marginal tax rate. If you take a large amount out of your pension in one go, this could push you into a higher tax bracket, so it can make sense to take out money gradually over several tax years if you’re able to in order to reduce the amount of income tax you’ll have to pay.
Read more about taking a tax-free lump sum from your pension in our article Should I take my tax-free pension cash at 55? and about tax on pension withdrawals in our guide How much tax will I pay when I withdraw my pension?
You could limit the amount you’ll be able to contribute to your pension in future
Anyone who takes more than their tax-free lump sum from their pension will see their Annual Allowance (the amount you can pay into your pension each tax year) fall from £60,000 to £10,000 and become known as the Money Purchase Annual Allowance (MPAA). If you plan to work for a few more years thinking that you can top up anything you take out now, then this restriction could have a significant unintended impact on how much you’ll be able to save for your retirement by significantly limiting any further contributions you can make. You can learn more about the MPAA in our article What is the Money Purchase Annual Allowance?
If you only take a 25% tax-free lump sum out of your pension but not any income, you can still hang onto your full Annual Allowance. Find out more in our article Understanding your pension allowances.
The more you take out now, the less you’ll have to live on later
Taking money out of your pension now might alleviate some of the financial pressure you’re currently under, but it’ll mean you have less to live on when you retire.
Ian Browne, retirement expert at Quilter said: “It is vital that if you do decide to use your pension more than previously planned that you think about the long-term consequences. It is not just that sum that you won’t have later on down the line, compound interest means the growth of your pot will also deplete.”
Compound interest is when income is reinvested to generate more income and gains grow on gains.
Rather than dipping into your retirement savings, you might want to look at ways you can cut costs and boost your income. Our article 21 ways to cut costs has lots of suggestions that may help you reduce your outgoings, while you should also ensure you are claiming any benefits you are entitled to.
Focus on the long term
Market volatility can also prompt people to dip into their pension savings so they can move their money into supposedly ‘safer’ homes such as savings accounts.
If you’re worried about falls in the value of your pension savings, try to avoid making any knee-jerk reactions.
Emma Byron, Managing Director of Legal & General Retirement Income said: “When markets are uncertain, or people see their investments have taken a hit, the urge can be to switch into cash or less risky assets like bonds. This reaction is part of human nature, and while it may feel like a sensible approach, in reality it means there is no chance for your investments to recover and you therefore crystallise investment losses that are currently only on paper.
“If you have time on your side, you should try to ride it out and let your investments recover over time. It’s important when making decisions at this time, to consider your needs thoughtfully and with the long-term in mind; retirement is a marathon and not a sprint.”
If you’re worried, check where your pension savings are invested as the funds you choose could have a significant impact on the income you end up with at retirement. Many pension schemes automatically move investors into lower risk investment as they approach retirement. Find out more in our articles Where is my pension invested? and Four ways to weather stock market storms.
If you’re thinking of transferring from a final salary to a defined contribution pension
Some people may be thinking about transferring away from their defined benefit pensions so that they can access their pensions savings. However, for the vast majority of people, giving up their final salary pension won’t be the right decision.
A spokesman for Interactive Investor said: “Guaranteed income is hard to come by and there are many reasons why keeping your defined benefit crown jewels will be the right choice for most people. Defined benefit plans pay a pension equivalent to a proportion of your salary, based on how long you worked for that employer. That pension is guaranteed and if you move it to a defined contribution plan, you’d be giving up that guarantee and may not be able to secure the same level of income.”
However, there are some isolated cases where transferring might be worth considering, for example if serious health issues mean you’re not worried about guarantees. In these circumstances, seeking professional financial advice is vital to help you weigh up whether or not you should transfer.
Carolyn Jones, Head of Pension Policy and Strategy at the Money and Pensions Service (MaPS) said: “The most important thing for anyone thinking about transferring to a different type of pension is that they take time to find out about all the implications by using the support available. People with a transfer value of over £30,000 must by law get advice before moving their money but it is always a good idea to get independent financial advice or guidance before making important, irreversible decisions.”
Find out more in our article Should I transfer my final salary pension?
Where to go for help
If you’re 50 or over and have a defined contribution pension, you can get free guidance on the options available to you from the Government’s Pension Wise service.
However, if you want personal recommendations or advice about your specific circumstances, you’ll need to seek professional financial advice. You can find a local financial advisor on VouchedFor or Unbiased, or for more information, check out our guides on How to find the right financial advisor for you or How to get advice on your pension.
If you’re considering getting professional financial advice, Aviva is offering Rest Less members a free initial consultation with an expert to chat about your financial situation and goals. There’s no obligation, but if they feel you’d benefit from paid financial advice, they’ll go over how that works and the charges involved.