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Taking tax-free cash from a pension: what you need to know

Paloma Kubiak
Written By:
Paloma Kubiak

The pension reforms of 2015 allowed those approaching retirement to access any amount of money from their pots, with the first 25% being tax-free. Here’s what you need to know about this rule.

What is the tax-free pension lump sum?

The pension commencement lump sum (commonly known as tax-free cash) is the amount of money available ‘tax-free’ as a lump sum after the minimum pension age, which is currently 55, rising to 57 in 2028.

The chance to pocket a tax-free 25% lump sum from your retirement fund is one of the most popular perks of saving into a pension. The potential uses of this cash are extensive, from paying down a mortgage to helping the next generation onto the property ladder.

But you don’t have to take it straight away. You can leave the money where it is until you’re ready to create a plan for your retirement. This could mean taking it out in one go, taking it in smaller portions over several years, or even not taking it at all.

How is the tax-free lump sum calculated for personal pensions?

Most final salary schemes allow a member to draw a one-off tax-free lump sum. However, the calculation method often means you get less than 25%. Sometimes this lump sum is offered at the cost of receiving a smaller starting pension – employers have the power to choose the rate. For other schemes the lump sum is automatically offered in addition to your guaranteed pension income.

Once you have selected your choice of pension benefits, you cannot change your mind in later years. Determining whether the offer is fair can be complex and advice should be sought.

Should I take a lump sum or keep it invested?

Once you reach the age of 55, you’re usually free to take money out of your personal pension(s) – as much as you want, whenever you want to do it. Of course, if you have no immediate plans to use the cash, you can leave it invested. As long as your money stays in your pension pot you won’t pay tax on it and you’ll get tax-relief on contributions you make.

If you take out your 25% lump sum and put it in the bank you will lose the tax advantages that come with pensions. Any interest that the money earns could be subject to income tax. It will also become part of your estate for inheritance tax purposes. If you don’t have an immediate purpose for your tax-free cash it is usually better to leave the money in your pension.

Leaving your money in an invested portfolio gives you the benefit of compounded investment returns. An extra 10 years of growth can make a big difference to your retirement income. The average 55-year-old will live to be in their mid-to-late 80’s so you are likely to need your pension to last.

If you decide to take your 25% tax-free cash, this means your pension is ‘crystallised’.

You will then need to decide what to do with the rest of the fund:

  • Keep it invested in an income drawdown plan: you’ll be leaving your money invested, so it has the potential to continue growing. You can draw taxable income as and when you need
  • Buy an annuity: use your pension to provide a guaranteed regular income for life
  • Cash in your entire pension: this may result in you paying a higher rate of tax.

It may be possible to mix and match what you do with your pension pot at different points in your retirement. Take time to think about the benefits and considerations of each option.

Should I take a lump sum in instalments over a period of time?

The pension freedoms introduced a new way to access your personal pension. You can now take a series of smaller lump sums when you need them. These are a combination of tax-free cash and taxable income.

If you drew £10,000 in this way you would receive £2,500 tax-free (25%) and the other £7,500 would be subject to income tax. It’s a useful way to manage the tax on your pension. It also means your remaining tax-free cash entitlement will continue to grow.

If you take any taxable income from your personal pension the amount you can pay into a pension to earn tax relief falls to £4,000 a year (Money Purchase Annual Allowance).

How much tax will I pay?

Spreading withdrawals over a number of years can minimise your tax bill and mean that your tax-free entitlement is spread over several years. Each withdrawal is 25% tax-free, with the rest charged at your normal income tax rate when your other income is taken into account.

How does the ‘small pot rule’ work?

If you’re over the age of 55 and your pension pot is £10,000 or less, it may be classed as a ‘small pension pot’.

In these circumstances, you can take the whole of your pension as cash, whether your pension is defined contribution or final salary (defined benefit). For personal pensions there is also the option of taking up to three small pots of £10,000 or less.

Just because you can take the cash doesn’t mean you will avoid income tax. As with all pension income, the first 25% of the cash will be tax-free but income tax will be levied on the rest of the money.

Can I take my pension lump sum and still work?

There’s nothing to stop you working as you take your tax-free lump sum. If you’re in a modern flexible pension, you can take your tax-free cash and continue to make contributions into your pension. There are rules to stop you ‘recycling’ your tax-free cash into new pension contributions though so take advice if this applies to you.

How does the tax-free lump sum affect inheritance tax?

Before the pensions changes were introduced, the ability to pass wealth to others efficiently via a pension was limited. Now you can nominate anyone to receive the remaining value in your pension.

This favourable tax treatment means it can make sense to draw an income from alternative sources in retirement, leaving the full value of your personal pension(s) to your loved ones. So long as it remains invested, the capital within the pension can even benefit from tax-efficient growth.

This is not possible with final salary schemes. In these schemes, any value remaining in the pension when you die is usually absorbed back into the scheme itself.

Get some expert help

Whether you’re thinking of taking money from a final salary scheme or a personal pension, or both, getting financial advice first will usually be sensible.

Jeannie Boyle is director and chartered financial planner at EQ Investors