This is not a decision to be made lightly, but if the alternative is spiraling into debt, temporarily suspending your contributions may be the least bad option.
Ten years ago, participation was the default option for workplace pensions. In 2012, in a bid to increase pension participation, the government introduced a subtle legislative change that made opting out of the employer pension scheme the default option. No one was forced to participate, despite the obvious financial advantages, but if people did not want to be involved, they had to consciously abandon the plan.
By any objective measure, this was a huge success. When the pandemic broke out in 2020, more than 90% of eligible private sector workers in the UK were members of workplace schemes. It’s not hard to see why: Even with the minimum set-up, an employee’s contribution of 4% of eligible earnings is matched by an additional 3% from their employer and 1% tax relief from the government. Many employers even offer to match their employees’ contributions at higher levels, so it’s an important decision to forgo that “free” money.
But that’s what workers increasingly do, pressed by short-term imperatives to feed their families and heat their homes.
If you are faced with such a decision, the first thing you should do is understand what is at stake and what you stand to lose. At the very least, if you stop contributing to your pension, you will lose the fight to your employer and the government. Look carefully at the design you intend to leave. Many employers contribute more than the minimum 3%.
If you still feel that once you’ve paid for the necessities of life, paying pension contributions will push you further into debt, then it might make sense to consider suspending your contributions temporarily while you clear your liabilities. After all, you can come back whenever you want.
This makes even more sense if, as is the case with those experiencing financial hardship, the cost of borrowing is high. With incomes not keeping up with the increased cost of living, expensive debt should be avoided at all costs and paying off balances should become a priority.
I’ve outlined a number of strategies for dealing with debt here, including the snowball method of paying off the most expensive debt first and the snowball method, which involves cleaning up smaller loans and working your way up. Also remember that you don’t have to do it alone. Services such as Money Helper, which provide free support on a wide range of financial topics, can guide you.
A parallel issue facing workers is that over-55s are drawing more pensions than in the past, often in lump sums and often while still working. Flexible withdrawals from pension plans increased by 23% in the second quarter of 2022 compared to a year earlier. It’s impossible to say exactly what the money was spent on, but it’s easy to imagine that at least some of it has gone to mounting bills and paying off mortgages.
This is another aspect of short-term financial imperatives outweighing long-term tax and savings benefits. Such withdrawals are clearly not economically viable, but they make sense if the alternatives are more expensive. One of the key issues with pension withdrawals, however, is making sure you don’t pay more tax than necessary.
Withdrawals are tax-efficient, but not tax-free. Once you reach the age of 55, it is usually possible to withdraw 25% of your pension fund tax-free. Any withdrawal beyond that is taxed at your marginal rate of income tax, which can be up to 45%. Furthermore, taking out more than 25% to meet a temporary commitment could severely limit your options for topping up your pension pot if things improve. The annual pension contribution allowance is £40,000 ($46,412), but it drops to just £4,000 if more than the tax-free amount was already withdrawn.
If you’re struggling, it’s generally better to tap into your savings and investments first before reaching for the pension fund. You can withdraw your ISA savings tax-free and this will not affect potential future retirement savings. If pension withdrawals remain your only option, rolling them in at the end of the financial year in April can be more tax efficient, allowing you to offset the £12,570 annual income tax allowance twice (once for each tax year) against any withdrawal.
Stopping your pension contributions, or withdrawing from your fund early, is far from ideal, but it can make sense if maintaining your pension is unaffordable. However, in such aligned circumstances, it is even more critical that we do things as efficiently as possible while taking advantage of the free help out there, not just as part of Pensions Awareness Week, but on an ongoing basis.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Stuart Trow is co-presenter of ‘Money, Money, Money’ on Switch Radio and author of ‘The Bluffer’s Guide to Economics’. Previously, he was head of strategy at the European Bank for Reconstruction and Development.
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