The Institute for Fiscal Studies (IFS) have warned that hundreds of thousands of people may face a big tax bill if they decide to dip into their pension pots from next week. 

As of Easter Monday, anyone over the age of 55 will be free to cash in Defined Contribution (DC) pension savings. But the Director of the independent think-tank IFS has warned them to “watchpension and taxes out”. Apart from a tax-free lump sum of 25%, they will be liable for income tax on the remainder, and

if the amount being taken out, when added to annual income, exceeds £42,386, they will pay tax at the higher rate of 40% – and could face a bill for thousands of pounds.

“If you can keep your income tax below the higher rate threshold, you’re going to end up paying less tax than if you take it in a big lump,” said the IFS Director, adding that the Treasury is hoping to benefit to the tune of £0.5 billion in 2015/16, partly because some people will be caught in the tax trap. By 2018/19 it expects to raise an extra £1 billion as a result of people cashing in their pensions.

Tax ‘shock’

Bill Miller, a 61 year-old former local government worker from South London, is one of those who were unaware of the full tax implications. He is considering withdrawing the full £125,000 he has saved in his pension. However, since he already has an income of £31,000 from other sources, he faces a one-off tax bill of £43,500.

Even allowing for 25% of his windfall being tax free, he would move into higher rate tax band. And since his income for the year would be £124,000, he would also lose all of his personal allowance, the amount you can earn before you pay tax.

“That’s news to me,” he told the BBC. “It’s a shock. I’ve been saving for my pension all of these years, and I don’t want to lose it. And there’s a danger I could without realising.”

Only 34% already knew how much, if any, of their pension savings would be taxed if they withdrew them all at once, whilst another 68% felt that the government did not make the tax implications clear when they announced the pension freedom reforms.

How many could get caught in the tax trap?

According to separate research from Old Mutual Wealth, approximately 1.7 million people eligible to access their entire pension savings from next week don’t know that pension income is taxable and that they could potentially face a tax bill.

However the number at risk could be higher, because one in four people do not fully understand the tax treatment of pension income – and that normally, 25% can be taken tax free with the remaining amount taxed at someone’s marginal tax rate.

Only time will tell how long it will take the over-55s to appreciate this risk and be more careful about withdrawals from their pension pot, but it seems that it’s not in the government’s interests to issue helpful, cautionary guidance on this issue any time soon.