Financial journalist Faith Glasgow provides everything you need to know about the forthcoming pension reforms and the tax issues involved.
Pensions have never been so exciting. Indeed many would say pensions have never been even remotely exciting, because the whole system has been set up to be secure, inflexible - and dull. But major changes are on their way: April sees the start of a new pension regime that for the first time will give people real choice as to what they do with their pension pot at retirement.
April's changes were outlined in the March Budget last year by the chancellor, George Osborne, and the open up a whole landscape of new possibilities. From 6 April, you'll be able to access your pension pot freely at any time from the age of 55. You'll still be able to take 25 per cent of your fund tax-free, either as a single lump sum or as a tax-free 'layer' of a series of lump sum withdrawals. But you won't have to buy an annuity, or to do anything with your pension at any particular time.
So you could leave it invested to grow some more if, for example, you're still working; you're even allowed to carry on paying into it (up to £10,000 a year). Or you could take out a series of chunks as cash lump sums; or draw a regular income; or indeed buy an annuity with some of it.
The possibilities are numerous, but according to research by broker Hargreaves Lansdown (hl.co.uk), the signs are that most people will opt for a combination to give them both greater flexibility and some security of retirement income.
But although the point of pensions is to support us through our non-working years, there is no longer any obligation to use your pot that way. When the changes were first announced in March 2014, there was concern about people rushing out to blow their retirement fund on Lamborghinis, cruises or buy-to-let properties, but Hargreaves Lansdown's research finds that in reality, 'investors won't necessarily blow the cash: many are already showing a prudent approach'.
However, if you have plans to buy an overseas property - whether to rent out or exclusively for your own use - you may be tempted to use some of your pension fund for it. It may make sense, but there are significant pitfalls, so look at the pros and cons and ideally take professional advice before you commit yourself to anything.
Certainly there are sound arguments for buying overseas at this time. 'The main advantage of buying overseas at the moment has to be the price/value for money, with such large falls in property values in some places,' says specialist IFA Richard Alexander (ra-fp.com). That attraction is bolstered by the currency situation: with the pound currently at its strongest against the euro since early 2008, European properties work out even cheaper for prospective buyers paying in sterling.So, how might you use your pension pot to fund your purchase?
It's probably easiest to answer this by looking at the potential problems involved. There are two big ones. The first is the obvious one: your pension is designed to fund your retirement - so if you use it to buy a property instead, you need to be sure either that the property will produce a sufficient income to support you, or that you have sources of income to live off.
The second problem is about tax, and it becomes more of an issue with larger pension pots. As Julian Broom, pensions expert at expatriate special advisers The Fry Group (thefrygroup.co.uk), explains: 'After the 25 per cent tax-free cash, you'll be taxed on any withdrawals at your top rate of tax, so if you have £100,000 of pension you will pay tax on £75,000 of it. If you're a higher rate taxpayer that means you could lose £30,000 in tax. Clearly that's a huge hit.'
'Tax is the big thing,' agrees Gareth Bertram, director of John Charles Property (johncharlesfinance.co.uk). 'People withdrawing money beyond their tax-free amount will very quickly find they push into the 40 per cent tax bracket, so that means doing some serious calculations including every source of income - state pension, rental property, savings and so on as well as private pensions - to work out at what point you'll hit the higher tax band.'
If you have a pension pot of only, say £20,000 or £30,000, this is much less likely to be an issue and it may make sense to take out the whole lot. Bearing in mind that the average UK private pension fund is only worth around £35,000, it's clear that many people will fall into this bracket.
Brooms suggests that for larger pension pots where tax is a potential problem, it makes sense to be canny and stage your withdrawals. 'Take the tax-free cash plus additional taxable cash up to the basic rate tax limit this year, and then use a mortgage to fund the balance. You can then draw out up to the basic rate threshold each year to pay off the mortgage.'Richard Alexander agrees. 'With banks starting to lend on property again and with interest rates set to remain low for some time, borrowing to fund the purchase may make a lot of sense, but a sensible balance needs to be maintained,' he says.
Lump sum tax: an example of £35,000
If you take a pension lump sum, then assuming the first 25 per cent is tax free you will have to pay tax on the balance at a rate that takes your other income into account. For example, say you had a gross income of £25,000 and wanted to take £35,000 of pension. You would receive £8,750 of pension tax free and pay tax on the remaining £26,250. That is added to your £25,000 of income.
The first chunk of pension, up to the 40 per cent tax threshold, is taxed at 20 per cent, and the balance above the threshold is taxed at 40 per cent. As of April 2015 that would amount to a total of £7,023 of tax payable on your pension. (Basically, as your other income rises nearer to the higher rate tax threshold, more and more of your pension is taxed at 40 per cent.)
Don't bank on a full state pension
If you're planning to put a substantial chunk of pension towards a property, you may be counting on the state pension, which will rise to around £148 per week from April 2016.
But be warned: Hargreaves Lansdown has received evidence from the government that less than half of those retiring between 2016 and 2020 will be eligible for the full state pension, either because they haven't paid a full 35 years' of national insurance contributions or because they opted to build up their private pension rather than receive the full state pension. Almost a third of those will receive less than 85 per cent of the full amount, according to Hargreaves.
'With the new pension freedoms meaning that people will be free to spend all their private pension savings, it is imperative that they receive a proper state pension forecast. Without this, they could get a nasty shock when they do reach state pension age,' warns Tom McPhail, head of pensions at Hargreaves.
You can check your pension via the gov.uk website.
(This article was first published in A Place in the Sun Magazine.)