Drawdown disaster warning as simple pension withdrawal error triggers £27,400 tax charge

Britons continue to take advantage of pension freedoms with almost three in five retired over-55s withdrawing cash from their pot before they hit state pension age. Many do so to bridge the gap until they qualify for the state pension at 66 to see them through after ill health, redundancy or a drop in earnings.

More than half say they retired sooner than expected or planned and therefore needed the extra cash, according to retirement specialist Just Group.

Just's communications director Stephen Lowe said accessing pensions early can help people cope with rising living costs or unexpected events but is risky. “Pension spent before retirement will not be available to provide income later in life.”

There is another danger. While savers can take 25 percent of their pension as a tax-free lump sum, further withdrawals will be added to their annual earnings and may be liable to income tax.

The bill can be huge and ravage your retirement pot, especially if you take a large sum in a single tax year, new Standard Life figures show.

Between October 2022 and March 2023, some 221 people fully encashed a pension of more than £250,000, on top of their tax-free cash.

As a result, they handed over at least £97,500 to HM Revenue & Customs.

In practice, most will have paid a lot more as they had income from other sources, too.

An additional 1,537 people fully encashed pots worth between £100,000 and £249,000. In doing so, they will have triggered a tax bill of at least £27,400 each.

These bills are likely to be even around £1,000 higher today, as the threshold for paying 45p additional rate tax threshold was cut from £150,000 to £125,140 in April 2023.

In many cases they could have been easily avoided.

Making a large lump sum pension withdrawal can cost you dear, by pushing you into a higher tax bracket.

It could even see a 20 percent taxpayer paying 40 or 45 percent tax for the first time in their life, swallowing almost half of their pension in one go.

Standard Life's retirement savings director Mike Ambery said its figures show that pension savers are accidentally handing over huge sums to HMRC, simply to access their pension. “For the vast majority this is something you’ll want to avoid.”

Making much smaller withdrawals while also earning income from a job could backfire by pushing you into a higher tax bracket, he warned. “Fully encashing a large pot will almost always mean a large tax bill, sometimes taking away years’ worth of savings.”

Another mistake is to withdraw money and simply move it to your bank account. "That way your savings become eligible for tax, plus you are potentially giving up investor returns, too,” Ambery said.

Never withdraw money from your pension unless you really need it, he added. “Taking small, regular chunks could keep your tax bill down."

Pensioners should consider a “mix and match” approach, using a portion of their pension to buy an annuity to cover essentials, and leaving the rest in drawdown to pay for one-off spending and treats.

Pension is not taxed when used to buy an annuity. The subsequent income will be, but at least that spreads the bill.

You only pay income tax on anything over your personal allowance, Ambery said. “If your pension pot is your only source of income, you could take £12,570 each tax year and not pay any tax at all.”

You do not need to take your tax-free cash in one go. Most plans let you take it in chunks over a number of months or years to top up your income.

It is maybe possible to organise your pension withdrawals so that you do not pay any tax at all, while still having enough to live on.

This works best before you start claiming the state pension, which is added to your income when assessing your annual tax liability.

So you could withdraw, say, £1,000 of taxable pension every month. That adds up to £12,000 a year, which is below the personal allowance.

Then you could combine that with £1,000 of tax-free cash. “That would give you £2,000 a month without paying any income tax, unless you have other earnings,” Ambery said.

You could supplement this with withdrawals from a cash or stocks and shares Isa, if you have one, as these are all tax free.

As you get further into retirement costs often fall, especially if you have paid off a mortgage and the children no longer need financial help. Ambery said: “The less pension you take, the less tax you pay.”

Pension withdrawals are be complicated with huge scope for errors.

So do your research first. If still unsure, consider taking independent financial advice. As these figures show, there's a lot of money at stake.