The coronavirus crisis has had an impact on everyone’s finances – for better or worse – and many over-55s have been forced to turn towards their pension to plug the income gap.
“Drawing down” from your pension, however, can come with a hefty tax bill so it’s important to understand the implications of dipping into your pot.
Whether you are still paying into your pension, approaching retirement age or already a pensioner, there are several tax pitfalls to avoid.
Pension tax traps to avoid
1. Understand your tax relief entitlement
Claire Trott, of wealth adviser St. James’s Place, said the first step was to make sure you understood your pension scheme and how you received tax relief on it.
Anyone who is over 22, employed and earning £10,000 or more will be automatically enrolled into a pension scheme chosen or run by your employer. A minimum of 8pc of your earnings will be invested for your future. You will contribute 4pc, your employer 3pc and 1pc comes via a Government top-up known as tax relief.
If your contributions are paid before you pay tax then you don’t need to do anything, your scheme will be getting full tax relief. This automatically increases the value of your pension before even taking into account investment growth. This is granted automatically at 20pc of the amount going into your pension.
However, if you pay your pension contributions after you pay tax, say in a self-invested personal pension (Sipp), then you will only be getting 20pc by default and need to reclaim any higher or additional rate tax, Ms Trott said.
For example, if you pay £80 into a Sipp, that will be boosted to £100 regardless of how much income tax you pay but a higher-rate taxpayer could claim back a further £20 while an additional-rate taxpayer could claim £25 extra.
This can be done via a self-assessment tax return or by calling HM Revenue & Customs and must be done every year to make sure the right amount of tax relief is given. You should do this even if you get an annual allowance charge.
You can claim any missing relief up to four years back.
When markets fall or money is tight, pension contributions can often be one of the first things to stop, but it can be advantageous to make contributions in a volatile market thanks to the effect of pound-cost average. This means that you can buy shares with the money in your pension fund at different prices, meaning you can get more for your money on average.
Tom Selby, of pension provider AJ Bell, said: “The combination of tax relief, tax-free cash from age 55 and a matched employer contribution makes pensions a difficult investment to beat.”
Michelle Gribbin, of pensions advice firm Profile Pensions, said the pandemic could force many to look for new jobs, possibly with lower salaries.
She said: “If you have been subject to a drop in income you may be tempted to opt out of a pension scheme until you’re more financially stable. But it is likely that, if you opt out, you won’t be able to rejoin at a later date.”
Your pension is essentially an extension of your pay and you would not turn down a pay rise, so consider that you may be losing out on contributions from your employer and the Government which are a valuable part of your benefit package.