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With less than a month to go before the Budget on November 26, speculation continues to grow about possible changes to the 25% tax-free lump sum available to most savers when accessing their pension.
Some advisers report a surge in people wanting to withdraw tax-free cash ahead of the budget, despite the fact that this could have significant long-term financial consequences.
Jamie Jenkins, director of policy at Royal London, said: “For example, some people may still be saving towards their retirement, and taking 25% tax-free now could be worth less than had they left it until their overall pension pot grows further. Also, if the money isn’t needed immediately, holding it in a bank account may depreciate its value over the years that follow, instead of remaining invested in their pension and benefiting from potentially higher returns.”
Here, we look at some of the issues that could arise from taking a big chunk out of your pension now, as well as why the Chancellor might well decide that changing tax-free cash rules will cause more problems than it is likely to solve.
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How much tax-free cash can you take from your pension?
Under current rules, usually you can take up to 25% of your defined contribution pension as a tax-free lump sum once you reach the age of 55 (rising to 57 in 2028). The maximum tax-free lump sum you can take is £268,275. This cap is based on the old Lifetime Allowance of £1,073,100 — so only those with pots larger than this can currently take the full £268,275.
If your pension is smaller than that, you can still take 25% of it tax-free, and this wouldn’t change unless the government reduced the maximum tax-free amount.
Once you’ve taken your 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 withdrawals beyond your 25% tax-free cash will be subject to income tax at your marginal rate. Read more in our article Your pension options at retirement.
You can spend your tax-free pension cash on whatever you want, with some people choosing to use the money to pay off a mortgage or clear other debts, or to give some of their savings to loved ones.
However, if you don’t have a good reason to withdraw your pension tax-free cash, think carefully about whether you may be better off leaving your retirement savings to grow tax-free for longer. Find out more in our article Should I take a tax-free lump sum from my pension?
Beware pension recycling rules
If you’re considering taking your tax-free cash due to Budget speculation, don’t assume you’ll then be able to pay it back into your pension if no changes to pensions are announced.
HMRC has tightened up its guidance since the 2024 Budget, so if you do decide to take your tax-free cash lump sum, this time you won’t be able to reverse that decision if no changes are announced.
There are also specific pension recycling rules in place which aim to prevent savers from doing this, so that they don’t receive tax relief twice. Rachel Vahey from AJ Bell said: “In broad terms, this means that where someone has taken their tax-free cash, their contributions cannot increase significantly above what they would normally have been, either before they take the lump sum or after. On top of this the person must not have intentionally withdrawn the money with the aim of recycling their tax-free lump sum.”
If you fall foul of these rules, you risk being hit with a hefty tax bill which could wipe out a large chunk of your retirement savings.
Can I still pay into my pension if I take my tax-free lump sum?
If you’ve sought advice and are still convinced that taking your tax-free lump sum now is right for you, then it’s worth noting you’ll still be able to continue to contribute to your pension in future.
Philip Lewis of Evelyn Partners explained: “Just taking the tax-free lump sum does not reduce the amount a saver can pay into their pension each year with tax relief, as the ‘money purchase annual allowance’ (MPAA) is not triggered. So most people who are not very high earners and subject to the tapered annual allowance can continue to pay in up to the annual allowance of £60,000 (depending on their earnings) even after they have taken their tax-free lump sum.
“This can be very useful to those who want to take their tax-free cash soon after they turn 55 but also remain in work and build their pension back up. The bad news is that HMRC will be watching out for large or increased pension contributions by those who have just taken their tax-free cash. If making pension contributions shortly after taking tax-free cash, it is important for savers to speak to an adviser about what is and isn’t considered ‘recycling’ under the pension rules.”
However, if you take out more than your tax-free lump sum, this will trigger the MPAA and your annual allowance will reduce from £60,000 to £10,000. You can find out more about how the MPAA works in our guide What is the Money Purchase Annual Allowance?
Why changes to tax-free cash are unlikely
Despite the fact that the Chancellor hasn’t denied that she could cut tax-free cash in the Budget, commentators claim there are several reasons she’s unlikely to tamper with it.
Mr Jenkins said: “Tax-free cash is one of the most popular and best understood features of pensions, and those that have amassed significant savings over a lifetime will often have plans for this money, such as paying off a mortgage, helping their children or grandchildren onto the housing ladder, or simply having the holiday of a lifetime as they enter retirement. Scuppering such plans is unlikely to be warmly welcomed.
“Second, there is the question of complexity. It sounds simple, reducing the amount from its current limit to something lower, but similar reductions to allowances in the past have usually been accompanied by a complex set of protections for people with existing entitlements. Protections which require monitoring and may last for years, possibly decades.”
There is also the issue of how much revenue any changes to tax-free cash limits would actually raise for the Treasury, especially as there would need to be protections put in plan, which would reduce any returns.
Rachel Vahey, head of public policy at AJ Bell, said: “Another reason why reducing tax-free cash won’t generate much revenue is because people will often spread income withdrawals over time, resulting in gradual income tax payments. While this constant drip of income tax wouldn’t raise much money in the short term, it may also lead to resentment and loss of goodwill and engagement.
“It’s important to remember that any changes would only affect those who have built up substantial pension savings, and not all pension savers.”
A final thought…
Removing your whole tax-free cash from an environment where it can grow tax-free without having any clear plan of what you are going to do with this money could prove highly risky, so make sure you seek professional advice before taking action.
Helena Morrissey of Hargreaves Lansdown said: “Rumours can be worrying but it’s important not to react in haste to something that may not even happen. This is money for your long-term future that needs to be planned for carefully, otherwise you could be left counting the cost. This could be due to missing out on investment growth, poor interest rates and tax charges that come out of nowhere.”
Bear in mind too that this time you won’t be able to reverse your decision if no changes are announced. Ms Vahey said: “Leaving money in your pension until you need it is normally the best course of action. It can continue to grow tax-free, meaning you should be able to take a bigger tax-free cash lump sum. If your pension is worth £400,000 today, your maximum tax-free cash will be £100,000. Waiting until it hits half a million – which may only take a few years with a decent rate of contribution and strong market growth – would give you an extra £25,000 tax-free.”
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If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide Chartered independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial adviser. 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 2,600 reviews on VouchedFor, the review site for financial advisers.
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