
As you approach your retirement years, the focus shifts from accumulating savings to how best to spend those savings. Decumulation is the process of gradually drawing down and spending your assets to support you during retirement. The aim for most of us is to maintain our standard of living without running out of money. But with various decumulation options and tax implications to consider, there are several pitfalls to be aware of along the way. Here are seven things to avoid when taking your pension.
1. Dipping into your pension before you stop working
From age 55 (rising to 57 in 2028), you can access your workplace or private pension. However, just because your pension savings are accessible, it doesn’t mean you should withdraw that money. If you’re still working or have alternative sources of income, aim to only take money from your pension if you need to cover your living costs.
Keeping your pension savings invested for longer allows you to benefit from the potential for future tax-free returns. This means that any growth in the value of your pension isn’t subject to tax while it remains in the pension. By leaving your funds invested, there’s potential for your 25% tax-free lump sum to grow. Plus, you also maintain a larger pot for income drawdown in the future. Withdrawing too much too early in your retirement leaves you at risk of running out of money in later life.
2. Withdrawing cash for it to sit in the bank
Taking more money out from your pension than you need to have it sit in a bank account can leave you worse off in the long run. Money within a pension has the potential to continue to grow tax-free. You’re not taxed until it’s withdrawn.
Financial products like pensions are examples of tax-efficient ‘wrapper accounts’ (a pool of different investments managed together). Unlike interest earned outside of the pension wrapper, which is subject to income tax, the returns on your pension can benefit from market movements, depending on how the pension is invested. This means that your pension has the potential to grow in line with market performance, unlike the typically lower returns on current accounts that often lag behind inflation. Use our Inflation Calculator to find out how your pension could be impacted.
3. Restricting your ability to continue to pay into your pension
As soon as you withdraw a taxable income from your pension, this impacts how much you can continue to pay into it. Before you take any income from your pension, your annual contribution limit is up to 100% of your relevant UK earnings or £60,000 (whichever is lower) for the 2024/25 tax year. After you start taking an income from your pension, you trigger the money purchase annual allowance (MPAA). This means your maximum annual contribution becomes the lower of 100% of your earnings or £10,000. So if you want to continue building your pension savings, avoid taking pension income and triggering the MPAA.
4. Spending retirement investments in the wrong order
Pensions may not be your only source of income in retirement. Look at any other savings you have like Individual Savings Accounts (ISAs), investments and properties. Make sure you carefully consider the order in which you spend them to maximise tax efficiency. It’s worth remembering that the first 25% of your pension income is tax-free while the rest is taxable as earnings. This tax-free allowance applies up to a maximum of £268,275, known as the lump sum allowance. Although customers with certain HMRC protections may be able to withdraw a higher amount without incurring tax.
All investments fall within groups known as ‘asset classes’. An Independent Financial Adviser (IFA) can help advise how best to spend your different asset classes, taking advantage of your personal savings, dividend tax and capital gains tax annual allowances to minimise your tax bill. If an adviser is regulated by the Financial Conduct Authority (FCA) it’ll be included on its free register of authorised individuals, firms and bodies. MoneyHelper has a similar directory for those seeking independent pensions advice.
5. Becoming an accidental first-time high-rate taxpayer
Once you’re eligible, you can withdraw up to 25% of your defined contribution pension as a tax-free lump sum. But, you don’t have to take the full amount all at once; you can withdraw your tax-free allowance in stages. This approach allows you to leave the remaining funds invested for potential growth while also taking taxable income if you choose.
If you decide to withdraw income from your pension, keep in mind that the 25% portion of your total pension can be taken as a tax-free lump sum in one go. However, if you choose this option, all future withdrawals will be subject to the current rate of tax. Alternatively, you could structure your withdrawals so that 25% of each withdrawal is tax-free, while the remaining 75% will be subject to tax. This second scenario allows for a more gradual approach to accessing your pension funds.
You may have other income because you’re:
- still working;
- entitled to the State Pension (currently 66, set to increase to 67 in 2028); or
- receiving investment or property income.
You’ll need to be careful that drawing pension income doesn’t take you over the higher rate income threshold, where it’ll attract a higher rate tax of 40%. Or if you’re expecting to be a higher rate taxpayer, you’ll need to consider the 45% threshold for additional rate tax. You may want to reduce how much pension income you take to stay under the threshold.
6. Not shopping around for the best annuity rates
An alternative to pension drawdown is to buy an annuity. This converts your pension savings into a guaranteed annual income stream for life or for a fixed-term. The amount you receive is determined by your annuity rate. If you choose this option, you don’t have to buy the annuity from your pension provider - make sure you shop around to get the best rate available.
You can also mix an annuity with pension drawdown. So, you could use part of your pension to purchase an annuity and leave the rest invested to draw down from as and when you choose. This way you combine the predictability of an annuity with the flexibility of drawdown. Deciding between your options and buying an annuity is a big decision, so if you aren’t sure, seek help from an IFA.
7. Falling victim to pension scams
Be wary of any direct approach that comes out of the blue and cross reference with the FCA’s ScamSmart website, which includes a warning list of companies operating without authorisation or running scams. You can also refer to the Pensions Scams Action Group ScamSmart leaflet for more information. Finally, before taking any actions in relation to your pension, make sure that the company you’re using is regulated by checking the FCA register.
Summary
As you near retirement, it’s important to shift your focus from saving to spending your pension wisely. Decumulation is about carefully drawing down your savings to maintain your lifestyle - without running out of . By avoiding these seven pension mistakes, you can set yourself up for retirement success.
Emma Maslin‘s a certified Financial Coach and Mentor, Financial Wellness Speaker and Founder of multi award-winning personal finance education website The Money Whisperer. A former Chartered Accountant, Emma believes financial health and wellbeing isn’t a luxury just for the wealthy; it’s a basic need for all of us.
Risk warning
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.