- June 8, 2019
- Bob Quinn
- Financial Planning
Conventional wisdom suggests that as soon as you retire, you convert your pension. You take the nice big tax-free lump sum and you invest the rest in such a way that it will pay you enough money to live on for the rest of your life, you hope!
That’s the way it happens, isn’t it?
Not necessarily. Simply doing what everybody does could be very tax inefficient for you. I have some really simple advice. It goes like this:
Cash, investment, pension
On retirement, follow these steps:
- Use up cash first (there is a caveat on this one, which I’ll come to)
- Then cash out your investments
- Only then convert your pension
Yes, I’m suggesting you spend the money you have in the bank, the money that makes you feel safe and secure because if there was any kind of downturn or emergency you would have a nice buffer to tide you over.
Now before you shout objections at the computer, let me share with you the caveat.
The caveat is that you should ringfence a rainy day fund, which you would not spend. You might remember I recently suggested that three years’ living expenses would be an appropriate amount to keep.
Cash earns nothing
Live on anything you have over and above that. Do not break open the pensions piggy bank. There are several reasons why you shouldn’t and one of them is that these days – and for the medium term – savings are earning nothing in the bank or credit union or wherever they are.
Investments attract exit tax
Next, cash out your investments. Why? Well, you pay 35% exit tax on investments, and this tax is levied every eight years whether you exit the investment or not, so you might as well pay it all now. Release your wealth from any open-ended investments and live on the proceeds for as long as you can.
Only then cash in that pension.
It’s all about tax
There’s another very compelling reason for not rushing in to convert your pre-retirement pension into a post retirement fund.
Your pre-retirement pension grows tax free and your contributions to it are (up to generous annual limits) tax free.
But when you press the button to convert your pension, the tax benefits dry up.
You’re shouting at the computer again, aren’t you? Yes, indeed you do get a tax-free lump sum of up to 25% of the value of the pension, but do you need it now? It’s not going away, and you’ll still get it in a few years’ time when you do draw on that pension.
As soon as you convert that pension into a post-retirement fund, you’ll start paying income tax and USC on 4% of the value of your ARF (Approved Retirement Fund) every year, whether you withdraw it or not. This is the oddly named principle of imputed distribution – Revenue ‘imputes’ or assigns a 4% drawdown and taxes you on it at the marginal rate. So, don’t kick that off unless you have to.
Wouldn’t it be so much better to keep that pension investment live (and hopefully growing) until you really do need it? Pensions don’t have to be converted until you reach 70 or 75 depending on the scheme.
Stagger your pensions
And if you have a number of pensions, you can stagger them so that you don’t trigger the tax events all at once.
So you see, it’s just managing cashflow. You’ve done this all your life, so just step away from the cliff. You can be much more creative, not to mention clever, about your retirement cash.
Finally, it makes sense having an income tax liability every year. Tax credits are offered on a use it or lose it basis. Drawing down one of your pension pots may be a strategic move.
Lots to consider. If I can help you figure any of this out, don’t hesitate to get in touch – there’s 30 minutes talk time with me here.