New pension freedoms may push thousands into a higher rate tax bracket

17th November 2014

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Some 60,000 pension savers who take advantage of the new freedoms could potentially find themselves in a higher rate tax bracket.

According to retirement specialist MGM Advantage, savers who have been used to paying tax under the pay as you earn (PAYE) system at the basic tax rate could find themselves being drawn into the higher tax bracket for the first time, and potentially being landed with an unexpected tax bill down the line.

Even those earning £33,288, the average income for a pre-retiree, taking little more than £20,000 as a lump sum from their pension, could find themselves pushed into the higher rate of tax for a portion of their pension payment. Those taking a larger lump sum would find themselves paying a significantly higher effective rate of tax than they are used to.

Under new rules announced by the Chancellor George Osborne in the Budget earlier this year, from next April, retirees will be able to do as they wish with their nest-egg and will no longer to forced to buy an annuity. If they wish, they can take the lot as a lump sum.

Commenting on the implications of the overhaul, Andrew Tully, pensions technical director at MGM Advantage said: ‘The pension freedoms bring a new level of complexity and choice in how people access their pensions. One of my concerns, even with conservative estimates, is that many people could find themselves being dragged into the higher tax bracket and the self-assessment tax system for the first time.

“This could mean people either pay too little tax or too much tax, as well as the potential for hefty fines from HMRC for people who don’t complete their self-assessment on time.”

Once savers have taken their money, they cannot change their mind and as such the decision is irreversible from a tax perspective. For example, take someone earning £33,288 in 2015/16 tax year – the average annual salary according to official numbers for a pre-retiree. MGM explained that if they take a pension lump sum of £20,000, then the first 25% is tax-free (£5,000), and the remaining £15,000 is taxed as income. Earnings of £33,288 plus the £15,000 taxable portion of the pension lump sum make a total income of £48,288, taking the individual over the higher rate tax threshold of £42,285. The tax paid on the £15,000 pension payment is £4,200.60, or an effect rate of 28%.

Tully added: “Our research shows that the awareness of the tax implications of pension lump sum withdrawals is low, so there is a clear danger of people making ill-informed decisions. At a time when people have access for the first time to possibly the largest single sum of money in their lives, well-informed decisions based on the facts will be crucial in ensuring good customer outcomes. Proper financial advice will play a key role.”

MGM’s research also found there is a concerning lack of understanding around the implications for taking the whole pension pot as cash, with 59% of people aged over 55 saying they do not understand the tax implications of such a move. The analysis also highlighted that when the tax implications are explained, people are far more likely to leave their money in a pension wrapper and draw an income as needed, rather than taking the entire pot as cash in one go. The survey found that only 17% would be happy to pay tax on any withdrawal.

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