A helpful guide to taking a tax-free cash lump sum from your pension

When your chosen retirement date arrives, you can finally take the money you've spent years building up in your pension savings. The first 25% of your pension can normally be taken as a tax-free lump sum, while the rest will be liable to Income Tax at your marginal rate.

Pension Freedom rules, introduced in April 2015, provided a new, flexible way to use your retirement savings. The earliest most people can draw on their pension is age 55, rising to 57 from April 2028.

If you're planning to take your tax-free cash lump sum, there’s lots to think about

There are several good reasons you might decide to take a tax-free lump sum from your pension.

You might decide to use the cash to clear the last of your mortgage or other debts to reduce your outgoings in retirement. Or you may want to treat yourself to a new car, a holiday of a lifetime, or use it to make some home improvements.

However, just because you can take this lump sum from the age of 55, it doesn't mean you have to.

Two questions to ask yourself before you decide to take your tax-free lump sum

After working and saving for most of your life, taking cash from your pension may sound appealing, but there are two questions it’s worth asking yourself first.

1. Do you want to keep building up your pension?

If so, you may want to consider only accessing the tax-free cash while leaving the rest invested until you decide to make more withdrawals or set up a regular income.

You don't have to take the whole 25% tax-free lump sum in one go. So, if you don’t need the full amount, you can withdraw as much as you want and still take the rest later. Should your pension pot rise in value, this could result in a larger total tax-free amount.

2. Will you still have enough for your retirement?

Increasing life expectancy means your retirement could last for 30 years or more.

With the potential for many years of retirement ahead of you, taking too much cash from your pension too early could cause problems for you down the line.

An annoying quirk means you could be charged emergency tax on pension lump sums

An unfortunate quirk in the tax system, can mean that the first lump sum you take from your pension often won't be taxed correctly. This may result in you paying more tax than you need to.

This is because Income Tax is deducted from your lump sum through Pay As You Earn (PAYE), effectively the money is treated the same as a salary payment.

Since your pension company won't know your personal tax code for your first withdrawal, or about any income you have from other sources, it applies a “Month 1” tax code to your lump sum, which assumes the amount you've withdrawn is one-twelfth of your annual income.

As an example, if you withdraw £20,000 from your pension as a lump sum, the withdrawal would be treated as if it were part of a £240,000 annual income.

The upshot of this is that you could lose some or all of your personal tax-free allowance and a big chunk of your lump sum could be taxed at the highest 45% rate, even if your total income for the year is much lower.

HMRC should eventually repay this tax, usually at the end of the tax year. You can also reclaim overpaid tax by completing an online form to make your claim.

The good news is that this should only happen on the first withdrawal you make.

Take smaller lump sums as and when you need to

Alternatively, you can leave the money in your pension fund and take out lump sums as and when you need to.

The technical term for this is uncrystallised funds pension lump sums (UFPLS). In simple terms, this means that you haven't “crystallised” your pension pot by turning it into an income.

What is an uncrystallised pension lump sum or UFPLS?

Think of it as using your pension like a savings account – withdrawing cash when you need it, while leaving the rest to grow.

Sounds good, right? The catch is, there's often a lot more associated admin.

Each withdrawal is 25% tax-free, with the rest charged at your normal Income Tax rate, taking all your other income into account.

It's also worth noting that, if you take a taxable payment from your pension, your Annual Allowance (the total amount you can pay into pensions with the benefit of tax relief) will be cut to just £4,000 a year.

This is known as the Money Purchase Annual Allowance (MPAA), and it can make it much harder to build up your savings in future.

You could leave your pension untouched

If you don’t need the funds, leaving your pension invested for longer and delaying when you take your lump sum could provide you with more cash later.

By taking only what you need, the remainder could continue to benefit from investment growth, helping to combat the effects of inflation. Remember, the invested amount can fall as well as rise so the decision you make will need to be based on your attitude to risk.

There are Inheritance Tax (IHT) benefits to having unused pension pots

In some circumstances, unused pension pots can pass to a chosen beneficiary tax-efficiently. While the money you withdraw from your pension counts towards the value of your estate for IHT purposes, unused funds do not.

On death before age 75, you can normally pass 100% of your unused pension funds to your chosen beneficiary tax-free. On death after age 75, any unused funds you pass on will usually be taxed at your beneficiary’s marginal rate.

To establish the beneficiary, or beneficiaries, for your pension, contact your pension provider and ask for an Expression of Wish form.  

If you expect to have other, non-pension income in retirement, leaving a pension pot until last – and only taking tax-free cash if you need to – might be a tax-efficient way to pass on your wealth.

Get in touch

If you have a specific purpose in mind and you are confident that the regular income you are due to receive is sufficient for the whole of your retirement, tax-free cash can be a great option. But taking more than you need could see it lose value in real terms.

You’ll have many decisions to make in the run-up to retirement, but we're here to help. By taking a holistic view of your finances, we can work with you to put a retirement plan in place that is aligned with your lifestyle goals.

If you would like to discuss any aspect of your retirement plans, get in touch. Email info@aspirafp.co.uk or call us on 01454 623 495.

This article is for information only and does not constitute financial advice or a recommendation to any investment or retirement strategy you should seek Professional financial advice before embarking on any course of action. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation, which are subject to change in the future.

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.

Accessing pension benefits early may impact on levels of retirement income and your entitlement to certain means tested benefits.

Accessing pension benefits is not suitable for everyone. You should seek advice to understand your options at retirement.

The Financial Conduct Authority does not regulate taxation and trust advice, will writing and estate planning.

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