The Prime Minister Keir Starmer has warned that we should prepare for a “painful” Budget on October 30, triggering fears that tax-free pension cash could be in the firing line.
Under current rules, those with defined contribution pension schemes can usually take a 25% tax-free lump sum out of their pensions once they reach the age of 55, rising to 57 by 2028. However, different pension schemes can have different rules, so you’ll need to check with your provider to see at what age you can start taking retirement benefits from your pension. Find out more in our article Should I take a tax-free lump sum from my pension?
Given the black hole in public finances, many pension savers are worried that the Chancellor will restrict their ability to take 25% of their retirement savings tax-free, with many rushing to take their money out before the Budget is announced.
Here, we look at some of the pros and cons of taking your tax-free cash now, and why, if you’re considering doing so, you should make sure you have a clear plan for this money.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
What are current tax-free cash rules?
You can currently take a maximum pension tax-free cash lump sum of £268,275 out of your pension, which is equivalent to 25% of the old Lifetime Allowance. This is known as your Lump Sum Allowance (LSA). Find out more in our article How much tax-free cash can I take from my pension?
After you’ve withdrawn any tax-free cash the remainder of your pension may, for example, be moved into a drawdown plan, used to buy an annuity or taken as cash. Any wishdrawals beyond your 25% tax-free cash will be subject to income tax at your marginal rate. Read more about this in our article What are your pension options at retirement?
You don’t have to take the full 25% at once if you don’t want to. For example, you can take smaller regular amounts from your pension if you prefer, and opt for 25% of each of these payments to be tax-free. So, for example, if you had a bigger pension pot and were to take £2,000 from it each month, £500 of this would be tax-free whilst the remaining £1,500 would be taxable. Find out more in our guide How much tax will I pay when I withdraw my pension?
Will Labour scrap the 25% tax-free lump sum?
No-one knows for certain what will be unveiled in the Autumn Budget, or whether the 25% tax-free lump sum will be abolished, but one thing that is guaranteed is that such a move would prove extremely unpopular with pension savers.
The new government may consider fully scrapping the tax-free lump sum a step too far. Instead, there’s a chance it might look at reducing the maximum tax-free lump sum you can take, perhaps to £200,000, £150,000 or even £100,000.
Tom Selby, director of public policy at AJ Bell said: “Starmer and Reeves could, in theory, lower the amount of tax-free cash Brits are entitled to – or even abolish the entitlement altogether.
“However, this would be deeply unpopular and fundamentally undermine wider government efforts to boost long-term investing, including in UK Plc. It would also inevitably be hugely complicated, as those who have already built-up entitlements to tax-free cash under the existing rules would almost certainly need to be protected against a retrospective retirement tax. Furthermore, the overall amount people can access tax-free has already been scaled back significantly over the last 14 years, and if the current figure remains frozen, it will continue to be eroded in real terms.”
Remember, that any potential changes are all just speculation for now, and there’s a chance the government may leave the tax-free lump sum untouched and instead focus on pension tax relief – or they may not tinker with pensions at all. Learn more in our article What are Labour’s plans for your pension?
Things to consider before taking your tax-free cash
Taking a 25% tax-free lump sum from your pension shouldn’t be entered into lightly, and there are several things you’ll need to consider before you act.
1) What will you do with the money?
There’s little point taking your 25% tax-free lump sum out of your pension just for it to sit in a savings account, as over long term periods cash savings are likely to be eroded by inflation. If you invest this money outside your pension, you may have to pay Capital Gains Tax (CGT) on investment growth and tax on dividend income. It’s therefore a good idea to have a clear plan as to what you’ll do with it, whether that’s using it to pay down your mortgage or to cover everyday living expenses. Find out more about options for your tax-free cash in our article What’s the best way to use my 25% pension tax-free cash?
Bear in mind that there are rules which prevent you taking your 25% tax-free lump sum cash and paying it into another pension – if you do this there could be both tax consequences and extra charges to pay.
2) Think about inheritance tax (if it applies to you)
It’s worth remembering that, at the moment, pensions can be passed on free of Inheritance Tax (IHT), and are completely tax-free if you die before age 75. If you die after the age of 75, your pension will be taxed in the same way as income when your beneficiary (or beneficiaries) come to make a withdrawal. If you take money out of a pension, however, including your 25% tax-free lump sum, it will count towards your estate for IHT purposes. This is another benefit to delaying accessing your tax-free cash until it’s definitely needed. Bear in mind though that there is a chance that the new government may change Inheritance Tax rules in the Budget, so there’s a risk that pensions could be brought into the IHT net. Learn more in our article Can my pension be used to reduce inheritance tax?
3) It might affect any benefits you’re claiming
Your pension income will be taken into consideration when you’re assessed for means-tested benefits such as tax credits, Universal Credit and housing benefit, so think carefully about the impact that taking a lump sum could have on these and find out whether it will reduce your entitlement. Only savings worth £6,000 (£10,000 if you are over State Pension age) or less will not affect your claim for means-tested benefits. Find out more in our article How lump sum payments and savings can affect your benefits.
4) Consider the benefits of leaving your tax-free lump sum in your pension
If you’re thinking about taking your tax-free cash, remember that there are (for now at least) several advantages of leaving it in your pension for as long as possible. Importantly, any growth your fund enjoys within a pension will be completely tax-free, and if you don’t take your tax-free entitlement straight away, this will grow too.
Of course, investment returns aren’t guaranteed, so you’ll need to be comfortable accepting that there’s a level of risk involved. The other benefit of leaving your tax-free cash for now is that your pension fund will have a greater chance of supporting you throughout retirement. Given that many of us will spend several decades in retirement, taking out 25% of your pension early on and spending it could mean you run out of money too soon in retirement.
A final thought…
If you have a specific plan in mind for your pension tax-free cash, and changes to the amount you could take could derail these plans, then you may decide that taking your 25% lump sum is worth doing ahead of the Budget, just in case any radical changes are announced.
However, if you don’t have a particular need for the money, you’ll need to weigh up carefully whether you think it’s worth taking it out now, or whether you might be better off leaving where it is so you can benefit from the tax advantages pensions provide, and hopefully end up with a higher income later in life.
This area of pension planning can be complex and will almost always depend on your own personal circumstances, so it’s worth speaking to a professional financial advisor who can help you navigate this.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
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