Small pension pots can be tax efficient

When you reach 55 you’re allowed to access your pension savings. The trouble is that doing so can trigger unwanted tax consequences, but there’s an exception for “small pot” payments. Might you be able to take advantage of these?

Taking pension benefits

Since April 2015 most of us have had the right to access as much of our pension savings as and when we want, provided we’ve reached the ripe old age of 55. However, it’s rarely a good idea to take all the money from your fund in one go. Apart from losing the tax-free status which pension savings have there are other tax consequences.

Tax side effects

The most obvious consequence of taking a significant lump sum from your pension is that it’s added to your other taxable income (except for the first 25%, which is tax free) and might be enough to push you into a higher rate of tax. However, there’s a less obvious side effect.

Trap: Taking money, whether it’s all of your pension savings or just some it, will cap the amount of tax relief you can claim on future pension contributions – apart from in a few situations (see The next step ).

Tip: You’re allowed to take so-called small pots from your pension savings without it capping tax relief on future contributions.

What counts as a small pot payment?

A small pot pension payment is one which:

• doesn’t exceed £10,000
• is paid out of a pension plan that you have not drawn from already; and
• uses the whole of the money in the pension plan.

The rules allow you to take up to three small pot payments during your lifetime.

How will it be taxed?

Small pot payments are taxed in the same way as other pension lump sums. The first 25% is tax free and the balance is taxed as income. The pension company will deduct basic rate tax (20%) from the taxable part of the payment before sending it to you. For example, if you took a pension pot of £8,000, you would receive £6,800, i.e. £8,000 less (£8,000 x 75% x 20%).

Trap: If you’re a higher or additional rate taxpayer you’ll have to pay further tax on the payment as the pension company will only have deducted the basic rate amount. However, if you time taking your pension small pot well, you can delay paying the extra tax by up to 22 months.

Example: Bill took a small pension pot of £10,000 on 10 April 2016 from which the pension company took basic rate tax of £1,600. Because Bill is a higher rate taxpayer he owes HMRC another £1,600, but the self-assessment rules say that this isn’t payable until 31 January 2018.

My pots are too big!

If none of your plans are worth less than £10,000, you might be able to reorganise them so that at least one is. You could transfer a plan worth, say, £18,000 from one scheme to two others equally. There may be a charge for this. A cheaper solution is to ask your pension company if it can divide a fund into separate smaller ones. There might still be a small charge for this, and not all companies will allow it, but it’s worth asking.

To take a small pot pension payment you must be 55 or over and the pension plan must not be worth more than £10,000. Plus you have to take the whole fund, not just part of it. If you don’t have a pension plan under £10,000 you can transfer a larger fund to two or more small ones and then take a small pot payment.