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Five Traps of New Pension Freedoms

Avoid falling into these traps hidden in the new pension rules from April 2015…

From April 2015, pension investors will have the freedom to do pretty much what they like with their pension savings at retirement. Over 400,000 people are eligible to take advantage of the new rules next year. But are the pension freedoms a good thing or might they backfire?

Pensions minister Steve Webb admits the government expects some people to make wrong choices, given the new freedom on offer. Recently he warned “This coming April some people will get it wrong”.

We explain 5 possible traps that can be avoided.

No recommendation

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

You could turn into a 45% income tax-payer overnight

From age 55, you’ll usually be able to take up to a quarter of your pension as a tax-free lump sum, as most can do currently. This has not changed. The tax-free cash is yours to spend or invest as you wish. You can then take as much as you like from the pension, even the whole lot if you wish. However these withdrawals are taxable. The new pension rules could net the Treasury an extra £3 billion in tax receipts over the next four years.

The withdrawals you make will be added to the rest of your income in that tax year, and subject to income tax at your highest rate. It could push you into a higher tax bracket. At the extreme, you could instantly face being a top rate tax payer (45%) if you make a withdrawal which, combined with your other income, takes you over £150,000.

There’s another hidden trap, too. Your personal annual tax allowance (for most people this is £10,000) starts to be whittled down once your income exceeds £100,000. It reduces by £1 for every £2 of income you have over £100,000. So if your taxable income is between £100,000 and £120,000 (2014/15 tax year), you might effectively be subject to a tax rate of up to 60%.

You could run out of money and become reliant on the state

This is possibly the most dangerous trap of all, as it will only start to bite once it’s too late to do anything about it.

A pension is designed to provide income in retirement, which could last for 30 years or more. If you blow all your pension savings in the early years, or even unwittingly draw an income which is not sustainable over the long term (for instance if you keep your fund invested and it does not perform as well as you expect, or you take excessive withdrawals), your pension might not last as long as you do.

Few will want to be reliant on the state in their old age. Don’t underestimate your life expectancy (82% of the population seriously under-estimate this, according to MGM Advantage), nor downplay how much money you are likely to need to last your retirement.

You may be ready, but your provider might not be

One of the biggest unanswered questions on the new freedoms is whether pension firms will actually allow their clients to take advantage of them. The financial press has reported stories about pension providers struggling to get their systems ready in time.

The National Association of Pension Funds, which represents 1,300 funds with 17 million savers, has warned there could be severe delays. Major insurance companies have also predicted capacity concerns. There is no legal obligation for providers to be ready for April.

You could get a fine from HM Revenue & Customs

Savers with more than one pension will be required to notify some or all of their other pension providers once they start to draw from one of these pensions.

Most people will have a standard annual allowance of £40,000 when it comes to how much they can contribute to pensions, and receive tax relief on these contributions. But for investors who start drawing from their pension flexibly for the first time after April 2015, they will have the amount they can contribute to pensions restricted to £10,000, a reduction of three quarters.

The rules require the investor to notify all pension providers to whom they are still paying pension contributions, so that provider can apply the new lower £10,000 contribution limit. They need to do this within 91 days of receiving a certificate confirming they have commenced flexi access drawdown or starting to make contributions to the plan if later.

If they don’t meet this deadline the saver could be hit with a fine of up to £300, with further penalties if this is not met.

In the UK, people have on average 11 jobs over a lifetime, so this rule could involve liaising with multiple pension providers if you are still paying into them.

Don’t be rushed into a decision

Don’t feel you have to rush into any one product or decision, either now, or once the new rules take effect. Take your time. Find out your options and ask for an explanation of how things work in plain English. Check the small print, some options can’t be changed once you’ve gone into them.

If you don’t understand your options, or are unsure of the suitability of any investment for your circumstances, seek advice.  Our role as independent advisers is to make sure your retirement solutions are tailored to suit your needs.