Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Pension savers risk double jeopardy with bank account withdrawals
A staggering £17.5bn has been withdrawn flexibly from savers’ retirement pots since the pension freedoms launched in April 2015. But how are people spending it?
To find out, AJ Bell surveyed 370 people who have used the flexibilities – which allow you to spend your pension as you like from age 55 – to get an idea of where the money has gone.
The good news is plenty of the cash has been spent sensibly, with a quarter of withdrawals (£4.7bn) being used for day-to-day living and around £3bn being used to pay off debt and reduce interest payments.
A whopping £2.3bn has been used to fund luxuries such as holidays, cars and home improvements. While there’s nothing wrong with this, you need to remember the main purpose of your pension is to provide an income through retirement – a period which could last for 30 years or more.
Rather bizarrely, £1.6bn has been withdrawn and invested in other products such as ISAs. This makes little sense in most cases – pensions offer tax-free investment growth (the same as ISAs) and you’ll pay tax on 75% of the money you take out.
The bank of mum and dad (or maybe grandparents) is well and truly open for business, with £1.2bn being used to help people’s children. The buy-to-let market, meanwhile, has had a £1bn injection from pension freedoms investors.
Despite stories of people using the flexibilities to squander their retirement pot on booze and gambling, only a tiny fraction of withdrawals (£245m) have been spent on ‘entertainment’ such as eating out, season tickets or betting. Similarly, a tiny proportion (£60m) has been used to fund elderly care.
MISSING OUT ON INVESTMENT GROWTH
Perhaps the biggest concern is around the £3bn that has been withdrawn from pensions and shoved into a bank account.
While having some ready cash is usually sensible, it is hardly a long-term investment strategy – particularly with many accounts paying ultra-low interest rates and inflation eating away at your capital.
In fact, savers who do this risk double jeopardy as they pay tax on their withdrawals and then potentially miss out on valuable long-term investment growth.
As an example, let’s compare the outcomes of two people: one who withdrew their entire £100,000 pension and put it in a bank account paying 1% interest in April 2015, and another with a retirement pot worth exactly the same who chose to leave it within the tax wrapper and invest in the FTSE All-Share. Both had taxable incomes of £50,000.
The person who withdrew their pension first of all pays 40% tax on the withdrawal, meaning £60,000 went into their bank account. If this remained untouched and grew by 1% a year, by April 2018 it would have been worth £61,818.
By contrast, the person who left their fund invested (assuming 1% annual charge) would have seen their pot grow to £120,110 – almost double the size. They could then manage withdrawals to minimise their tax bills.
Tom Selby, senior analyst, AJ Bell