Biggest pension mistakes you can make

Preparing the financial side of your retirement is vital. Charlotte Gifford advises what to avoid

We all dream of living comfortably in retirement, but making this a reality is far from easy. While your parents or grandparents may have enjoyed a defined benefit (DB) pension – guaranteeing them an income for the rest of their life – today, the vast majority of us will need to think much more carefully about how we save into, manage and access our retirement income. Failing to save enough or making poor drawdown choices are just a couple of ways you could find yourself running out of money.

Here, Telegraph Money outlines the biggest mistakes you can make with your pension, and how to avoid them.

THE WRONG TYPE OF WITHDRAWALS – AND PAYING TOO MUCH TAX Savers have a number of different options for drawing down their pensions.

But the rules are complex and making the “right” type of withdrawal can be a challenge – especially as the cost of living crisis has forced many to tap into their retirement savings earlier than expected. The amount flexibly withdrawn from pensions rose 15pc to £12.9bn in 2022-23.

But it requires careful thought and planning. For one thing, by rushing into a pension withdrawal, you risk paying more tax than necessary.

You can access your pension from age 55 (rising to 57 in 2028). If you have a defined contribution ( DC) scheme, you can opt for flexible retirement income, where you crystallise your pension in order to take 25pc of your pot tax-free. Subsequent withdrawals will be treated as taxable income.

Kate Smith, of pension firm Aegon, pointed out one major mistake. “People spend years diligently saving in a pension and risk losing the full benefit of this if they withdraw all their pension in one tax year and cross into a higher tax bracket. This could significantly reduce their retirement income after tax is deducted.

“It would be better to spread any pension withdrawals over a few years to avoid moving into a higher tax band and getting more of your pension in your pocket.” If you want to access your pension, but you do not want to designate funds for drawdown or buying an annuity just yet, then you can take what is called an “uncrystallised funds pension lump sum” (UFPLS).

This means 25pc of each withdrawal will be tax-free. For example, if you withdrew £5,000 then £1,250 would be tax-free and the remaining £3,750 would be added to your taxable income. Be careful not to withdraw more than you need, as this could push you into a higher tax bracket.

A study of more than 3,000 savers by the Association of British Insurers ( ABI) recently found that 86pc make the wrong decision – ie pay too much tax – when taking a UFPLS without detailed guidance. Once you start taking an income from your pension pot, the Money Purchase Annual Allowance kicks in.

This reduces how much you can save into your pension each year without paying tax from £60,000 to just £10,000. This can be very problematic for those who access their pensions while they are still working, or those who take up a job later in life.

ACCESSING YOUR PENSION

TOO EARLY

Just because you can access your pension from age 55, it does not necessarily mean you should. A saver taking their 25pc lump sum from a £400,000 pension pot will miss out on £24,618 worth of investment returns over the next five years, according to analysis by Aegon.

Resisting the urge to tap into your pot and leaving it untouched for as long as possible will give your money more time to benefit from tax- free growth and compound interest. If possible, you should also avoid raiding your pension to cover costs in later life.

Unlike other parts of your estate, pensions can be passed on free from inheritance tax – so, if your boiler breaks, for example, it would be better to take the money from your savings than your pension.

NOT SAVING ENOUGH

It is both boring and painful to hear, but it is true none the less: many of us are not saving enough for retirement. Thanks to auto-enrolment, over 20m employees now participate in a workplace pension, which is an improvement compared to before the rules kicked in – however, a large number pay only the bare minimum into the scheme.

Under auto- enrolment law, your employer must ensure your minimum pension contributions are 8pc – usually split as 3pc from them and 5pc from you. While this is better than nothing, it’s unlikely to be enough to build up enough for a comfortable retirement.

Andy Parker, of consultancy Barnett Waddingham, said: “Many never change from this auto- enrolment level. However, contributing the absolute minimum to your pension is unlikely to be the best approach to ensure you have a healthy pot for retirement.” Around 54pc of workers save less