Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Pension tax-free cash: What are the rules and does it always pay to take it?
Of all the benefits of saving in a pension, perhaps the best understood is the ability to take a quarter of your fund tax-free from age 55. As a result, getting at this money is a priority for millions of people approaching retirement.
In fact, research carried out by the Financial Conduct Authority, a regulator, suggests accessing tax-free cash is by far and away the biggest reason cited by investors for entering drawdown.
This article looks at the rules governing pensions’ tax-free cash, the options and whether you should always take it as soon as you can or leave your money invested in a pension?
HOW TO GET YOUR TAX-FREE CASH
There are two ways you can access tax-free cash from your pension from age 55.
The first and most popular is to take the full 25% as a lump sum. In order to do this you must choose what to do with the rest of your fund – the normal decision is to either stay invested in the stock market and take an income through drawdown or buy an annuity from an insurance company.
It’s worth spending some time considering which option best suits your needs. This is particularly important if you’re going to buy an annuity as this decision is irreversible.
For those entering drawdown it still makes sense to review your investments, provider choice and withdrawal strategy when you access your tax-free cash, but you don’t have to start taking an income from your remaining pension or alter your underlying fund if you don’t want to. Indeed, in many cases entering drawdown will have no impact on your investment strategy.
Alternatively, you can take ad-hoc lump sums from your fund (referred to as ‘Uncrystallised Funds Pension Lump Sums’ or ‘UFPLS’ in the jargon). If you go down this route, 25% of each withdrawal will be tax-free with the remaining 75% taxed in the same way as income.
TAKE IT OR LEAVE IT?
Just because you can do something doesn’t necessarily mean you should. While taking your pension tax-free cash as soon as possible might be tempting, in some cases it can be better to hold off. You should at least consider what you’re going to do with the money before taking it out.
Research commissioned by AJ Bell suggests around 14% of money withdrawn from personal pensions is invested in bank accounts. If the account pays low or zero interest, its value will be eroded over time by inflation.
Take someone with a £100,000 pension pot who, rather than accessing their tax-free cash at 55, holds off 10 years until they are 65.
If their fund grows by 4% a year after charges, at age 65 it will be worth £142,000 – generating almost £36,000 in tax-free cash. Or to put it another way, £11,000 more tax-free cash than if they’d taken it at age 55 and put it in a bank account paying 0% interest.
If you need to take some income from your fund and don’t want to take your entire 25% tax-free cash right away, taking ad-hoc lump sums from your fund could be an option worth considering.
In the above example, someone who took £5,000 a year from their fund through UFPLS in each of the 10 years would have a fund at age 65 worth just over £85,000 (again assuming 4% investment growth after charges).
If they then took 25% of their remaining fund as tax-free cash at age 65, they would have received almost £34,000 in tax-free cash in total – £9,000 more than if they had invested the money in a bank account 10 years earlier.
THE INHERITANCE TAX DILEMMA
Anyone who prioritises passing money on to loved ones might also want to consider leaving their tax-free cash invested in their pension. Any money taken out of a pension will become part of your estate and subject to inheritance tax, meaning it could be taxed at 40% if your other assets are worth more than the £325,000 threshold.
In a pension, on the other hand, the entire fund can be passed on tax-free if you die before age 75 and it will be taxed in the same way as income if you die after 75.
So if your main aim is to enrich your beneficiaries, leaving your tax-free cash in your pension can make financial sense.
This is not to say you should always delay taking your tax-free cash. Those with high cost debts, for example, might be better off using some of their tax-free cash to pay off their borrowings. Equally some might prefer to use the money to help their children pay for university or get on the housing ladder.
Ultimately the choice of what to do with your tax-free cash from age 55 is entirely yours. But whatever you decide, it is sensible to consider carefully what you want to do with the money and which of the options fit best with your overall retirement plan.