In Focus: Tax  

Why it pays to do proper pension planning

This may be avoided by applying for protections prior to retirement, and/or mitigated by taking the excess amount in the form of an income instead of a lump sum.

If the excess is designated to pay income it will be taxed at 25 per cent, even if the fund is then fully withdrawn under the flexi-access drawdown rules at a later date, as that withdrawal would in itself be subject to income tax.

People should also be aware that the first income withdrawal from their pension is likely to be taxed under the emergency rate of income tax.

This means the tax code for this income will be set on the assumption that the initial amount is the first of a regular income stream, even if it is actually a one-off payment.

It is possible therefore for the tax code to be based on an amount which is up to 12 times the value of the actual withdrawal. The excess tax will eventually be refunded but it can come as a nasty shock at the time.

The easiest way to avoid this situation is by withdrawing smaller amounts at first and increasing income once the tax code has been confirmed. 

FTA: How can pensioners get up to £30,000 a year without getting hit by tax?

FT: For people who are fortunate enough to have a range of investments, the most tax-efficient order of encashment after the PCLS is:

  • Isas, where all withdrawals are free of tax (apart from the Lifetime Isa if money is withdrawn before age 60 and not used for a first home). Using the Isa allowance of £20,000 each year makes sense not just in the year of investment but also when it comes to withdrawing money in retirement.
  • Income-producing investments up to the value of any unused personal allowance, and the savings allowances for the year. For an individual with no other taxable income this could add up to an annual amount of £17,500 each year.
  • Utilising the dividend allowance could add another £2,000 of tax-free income.
  • Capital assets up the value of the annual capital gains tax exemption of £12,300. 
  • Taxable investment assets.

Then, and only then, taxable pension income. Not only is this income taxed when it is paid out, but any money left in the pension fund is almost certain to be free of inheritance tax on death, so it makes sense to leave as much there for as long as possible. 

FTA: Is tax the only consideration in pension planning?

FT: Of course tax is not the only consideration, and much will depend on what type of investments people hold and whether they are accessible or not.

Some investments carry early encashment penalties and others, such as rental property, may not be easy to dispose of.

It is, however, worth considering the eventual order of encashments, both when building up a savings portfolio and when starting to spend it. 

Simoney Kyriakou is senior editor of FTAdviser