It can be easy to think that a small pension pot won’t make a difference, and although £30,000 alone may be difficult to live off during your retirement years, the power of a smaller pension pot is still a valuable asset and can make a big difference to your standard of living in retirement.
For example, a £30,000 pension pot could bring in a handy monthly income of £1892 which could cover council tax, home and contents insurance and water bills. So even though the pot may be small, it certainly is mighty!
The temptation to cash in your pension can be hard to resist, but experts at pensions advice specialist, Portafina, highlight three key things you should consider before cashing in your smaller pension pots, and why maybe you should think again:
1. Check your tax-free cash first
From the age of 55, you can access up to 25% of your personal pensions tax-free. So, if you decide to take money from your pot, check if your tax-free allowance will cover your needs first. If it does, it means you won’t be handing anything over to the taxman, and you’ll still have valuable pension savings invested for your future.
2. Be clear on the tax implications
Any money you take from your personal pension pot over your tax-free cash allowance will be treated as income and therefore liable to income tax. Before you make any final decisions, make sure you know what the exact tax implications are. No-one wants to pay more to the taxman than they absolutely have to!
3. Remember the power of your pension
If you’re thinking of cashing in your pension to put it into a standard savings account, you might want to think again. A modern pension that’s properly invested is extremely powerful. Tax breaks and compound interest mean that your personal pension is capable of outperforming most other savings platforms. Whereas most bank current accounts pay little to no interest.
To help illustrate these considerations further, experts at Portafina reviewed the following real-life example of when it can be tempting to cash in your small pension pot. Looking at this in real life terms,
You’re 55 and earning £25,000 per year. You have a £30,000 personal pension and you need £5,000 to clear a debt. You decide to cash in the whole pension because it doesn’t feel like a huge amount and put what’s left, after you’ve taken your £5,000, in a standard current account earning 1% interest per year (which is pretty generous, unless you opt for a fixed-term deal).
In this scenario, you suddenly owe the taxman £4,730, which means you have £20,270 of your pension left to put into your savings account. After five years that remaining lump sum is worth £21,309.
Now let’s say you take the £5,000 you need from your personal pension and keep the rest invested. You owe the taxman nothing because that £5,000 is within your tax-free cash allowance. And, assuming an average annual pension growth of 5% after charges3, after five years your pot would be worth £32,084.
Jamie Smith-Thompson, managing director of pension advice specialists Portafina, said: “The bottom line is, smaller pension pots can be extremely valuable. If you are 55 or over and thinking of cashing in a smaller pot then seeking regulated advice could be the difference between paying a large, unnecessary tax bill or not.
“And if you have five, ten or more years until you reach retirement then it helps to know that the potential purchasing power of smaller pensions is very real. Essentially, it means more of those day-to-day bills are covered. And sticking to the principles of adding little and often and leaving your pot invested for as long as possible can make a big difference.”
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