Being able to take up to 25% of your retirement savings as tax-free cash from the age of 55 (rising to 57 from 2028) is one of the major benefits of pensions.
It can be difficult to decide on the best use of this money for you, and you don’t have to withdraw it all at once – or at all if you don’t want to. After all, taking a chunk out of your pension will have a big impact on your future retirement income, particularly if you take a tax-free lump sum when stock markets are down.
There are numerous reasons why people decide they do want to take their tax-free cash. One in five over-55s have spent or plan to use the money for home renovations such as a new kitchen or loft conversion, according to new research from Standard life. Property improvements are the most popular way to use tax-free cash, although 16% of over-55s choose to spend it on a new car, while 15% put the money towards paying off mortgages or other debts.
Some of the other uses of this money include everyday spending (14%), paying for a short term holiday (13%) or a longer term break (7%).
If you’re considering using your pension tax-free cash, take some time to consider the right option for you, and bear in mind that withdrawing this money in smaller chunks over several years can make more financial sense than taking out a big lump sum (read more about this below).
Here we outline your options and some of the things you need to consider.
If you’re thinking about getting independent financial advice, financial services company Fidelius is offering Rest Less members a free initial consultation with an independent financial advisor to chat about your finances, where you are now, and where you want to go.
There’s no obligation, but if they feel you’d benefit from paid financial advice, they’ll go over how that works and the charges involved. Fidelius is rated 4.7/5 from over 1,000 reviews on VouchedFor, the review site for financial advisors.
Pension tax-free cash: The rules
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). However, it’s important to check your particular pension scheme’s rules, as the age at which you can start taking retirement benefits can vary. If you have a defined benefit (also known as a final salary) pension, the amount you can take as a tax-free lump sum will again depend on your scheme’s rules.
Dean Butler, managing director for retail at Standard Life said: “One of the great benefits of a pension is that you can take a quarter of your pot without paying tax on a single penny of it, all the way up to a maximum of £268,275. If you’ve kept up your contributions and grown your pot over a number of years, this could equate to a substantial amount of tax-free money by the time you come to take your savings.”
The remainder of your pension after you’ve withdrawn any tax-free cash 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 in our article Your pension options at retirement.
Benefits of leaving your tax-free sum
If you don’t really need the money right now, consider whether you may be better off leaving your 25% tax-free cash in your pension to benefit from future potential growth.
Tom Selby, head of retirement policy at AJBell, said: “There is no ‘best way’ to use your tax-free lump sum, but it’s important to think carefully about what you want to do with the money, rather than simply taking it out of your retirement pot at the first opportunity.
“In fact, there are potential benefits to leaving your tax-free cash within your pension for as long as possible. Firstly, any growth your fund enjoys within a pension will be completely tax-free. Second, if your fund does grow, then the tax-free cash entitlement attached to it will grow as well – although of course investment returns are never guaranteed and can be volatile, particularly over the short-term. You also need to remember that your pension fund needs to support you throughout retirement, so taking out a quarter and spending it frivolously could leave you on a sticky wicket further down the line.”
Leaving your tax-free lump sum invested in your pension may be particularly beneficial if your investments have fallen in value, as they could benefit from future stock market gains, and leave you better off later in retirement.
For example, if you have a pension valued at around £200,000, you’re able to take up to £50,000 as tax-free cash. If your pension grows in value by about 4.5% a year for the next 10 years, your pension will be worth about £325,779 (before charges) and you’ll be able to withdraw a tax-free lump sum of about £81,000. This would see you not only benefit from investment growth, and a larger tax-free lump sum, but also save money in income tax on your remaining pension withdrawals. However, your pension investments may fall as well as rise in value, and no-one can be sure how investments will perform, and they may fall as well as rise. Read more in our article Should I take my tax-free pension cash at 55?
Bear in mind, too, that pensions can be passed on completely free of IHT, and completely tax-free if you die before age 75. If you die after age 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, 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. Learn more in our article Can my pension be used to reduce inheritance tax?
Should I use my tax-free lump sum to pay off my mortgage (or other debts)?
If you’ve got a mortgage or other debts then you may be tempted to use your tax-free cash to pay off all or some of your remaining balance. As interest rates have soared in recent years, it’s understandable that being mortgage-free may appeal. However, think about the basic principles of financial planning before paying off your mortgage with your pension savings.
Selby said: “Your first port of call should usually be paying off any high cost debts you have, then building a rainy-day fund in case of emergency. If you’ve got both of those sorted, you can start to consider things like paying off your mortgage early, if that’s a priority and you are able to, or looking at more luxury spending, like renovating your home or travelling. But make sure doing this in the early stages of retirement won’t jeopardise your lifestyle later on.”
The interest rate you are paying on your debts might affect your decision on whether to focus on paying these off or leaving the money invested in your pension. There are lots of different factors to consider, so you may want to seek professional financial advice to help you with your decision. You’ll need to consider whether, over the long term, paying off the mortgage might be a better option for your money than leaving it invested in your pension.
Your mortgage interest rate, current deal and when this expires should all be considered, as well as any other debts you have. Also consider whether you have other income that can be used to continue paying your mortgage repayments, when you plan to stop working or reduce your income. If your income is likely to fall significantly or fluctuate a lot in the years ahead, then paying off your mortgage may be a good idea. If you decide to do this, though, you’ll need to factor in any Early Repayment Charges (ERCs) if these still apply. These can amount to between 1-5% of your outstanding mortgage balance. It may make more sense to use smaller lump sums to gradually reduce your mortgage over time until your deal ends.
Taking your tax-free cash in smaller instalments
You don’t have to take the full 25% lump sum when you start withdrawing from your pension. You could, for example, take smaller amounts over time to supplement your pension income, through a flexi-access drawdown plan or by taking ad-hoc lump sums. This could mean that your pension savings go further, with more of your money left in your pot to grow over the long term.
For example, if you had a bigger pension pot and were to take £1,000 from it each month, £250 of this would be tax-free whilst the remaining £750 is taxable. Or you could use smaller lump sums to increase your income until you reach State Pension age, currently 66 for both men and women.
The simplest option is to draw so-called ‘uncrystallised’ pension lump sums’ (UFPLS) from your pot, without going into drawdown or buying an annuity. Every time you take a lump sum, the first 25% is tax-free and the rest is taxed as income. However, bear in mind that if you do this the maximum amount you can pay into your pension each year and receive tax relief on reduces £10,000 down from the usual £60,000 Annual Allowance, and becomes known as the Money Purchase Annual Allowance (MPAA). Read more in our article What is the Money Purchase Annual Allowance?
Ultimately, the amount you should ideally take from your pension and the best way to withdraw the money will depend on your personal circumstances. Remember that any withdrawals you make beyond your tax-free lump sum will be taxed as income. Read more in our article How much tax will I pay when I withdraw my pension?
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 tranches or a lump sum of your tax-free cash could have on these and find out whether it will reduce your entitlement. Find out more in our article How lump sum payments and savings can affect your benefits.
Alternative options
You should carefully weigh up the pros and cons if you’re considering using your tax-free cash lump sum for another purpose that isn’t an essential financial cost, such as paying off a mortgage, other debts, or to meet everyday costs. For example, this may include spending this money on a new car or luxury holiday. In this case, it’s particularly important to remember that you don’t need to withdraw the entire lump sum, and that you should only take what you need.
Other alternatives include, for example, using your lump sum to fund the costs of starting a new business or career change. You may want to give some or all of your tax-free lump sum to your children, and if you live for seven years after doing so no Inheritance Tax will be due on this money. Read more in our article Which gifts are exempt from Inheritance Tax?
Beware of simply taking your tax-free lump sum from your pension without carefully considering what you’ll use this for, and having a specific plan for this money. There’s little point taking this money out of your pension for it to sit in a savings account, for example, as over long term periods cash savings are likely to lose value compared to the rising cost of living. 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.
Remember, too, that having a tax-free lump sum to hand as you grow older may be helpful to fund the cost of care. Ultimately, once you’ve used your tax-free lump sum you cannot get it back.
Where to go for advice on your pension
If you’re 50 or over, you can get free guidance on the options available to you from the Government’s Pension Wise service.
If you want personal recommendations or advice about your specific circumstances, you’ll need to seek professional financial advice. Check out our guides on How to find the right financial advisor for you or How to get advice on your pension.
If you’re thinking about getting independent financial advice, financial services company Fidelius is offering Rest Less members a free initial consultation with an independent financial advisor to chat about your finances, where you are now, and where you want to go.
There’s no obligation, but if they feel you’d benefit from paid financial advice, they’ll go over how that works and the charges involved. Fidelius is rated 4.7/5 from over 1,000 reviews on VouchedFor, the review site for financial advisors.
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