The opportunity to take anything tax-free is always attractive, but especially these days as we hand over more money than ever to HMRC.
Officially known as the pension commencement lump sum, this perk would apply to £50,000 of a £200,000 pension pot.
Some use the windfall to clear their mortgage, others to pay for big-ticket items such as a new car, home improvements or dream holiday.
This makes saving into a company or personal pension a no-brainer, said Lorna Shah, managing director of retail retirement at Legal & General. “It’s another hugely valuable incentive, alongside tax relief and employer top-ups on workplace schemes.”
Yet as always when dealing with large sums, you must approach it with a cool head.
The first thing to remember is that you can take the tax-free cash and carry on working rather than having to retire straight away, Shah said.
“As long as you don’t go into drawdown or buy an annuity, you can continue to work and save into your pension pot whilst benefitting from tax relief on those savings.”
Once you start taking income from a defined contribution pension, you will trigger the ‘money purchase annual allowance’ (MPAA) which restricts future pension contributions to £10,000 a year.
You also lose the ability to carry forward unused pension annual allowances from the three previous tax years.
If you only withdraw tax-free cash, you will not trigger the MPAA and so can retain the full annual allowance, which is now £60,000.
Think carefully how much cash you need to take, Shah said. “Our research shows more than half who drew the maximum lump sum later said they took too much and should have left some invested until they needed it later.”
If you leave the money in your pension it will continue to grow free of tax, but if you put it in a bank account earning little or no interest, its value will be eaten away by inflation and you may even pay tax on the interest, she added.
If you leave your pension invested you should have more tax-free cash later as the value of your pot grows, said Tom Selby, head of retirement policy at AJ Bell.
A 55-year-old with a £200,000 pension who left it all to grow to age 65 would have £296,000, even if they didn’t make any further pension contributions. This assumes average growth of four percent a year after charges.
This means their 25 percent tax-free cash would have climbed from £50,000 to £74,000, Selby said. “That’s almost 50 percent more than if they had accessed the money at 55.”
Remember that money held in a pension is free of inheritance tax when you die. “The moment you withdraw the money, it becomes part of your estate,” Selby said.
There have been constant rumours that the government will target the 25 percent tax-free lump sum, he added.
“Some withdraw theirs just in case it does, but it is unwise to base crucial pension decisions on speculation that may prove unfounded.”
Wealthier pension savers are limited to maximum tax-free cash of £268,275, despite the scrapping of the lifetime allowance.
It would take a brave politician to scrap or scale back this massively popular perk for tens of millions with smaller pots and a vote at the next election.
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Some defined benefit “final salary” workplace pension schemes, which pay a guaranteed income based on salary and years of service, may also offer a tax-free lump sum, Selby added.
“However, taking this may reduce your annual pension, so make sure the income will still deliver your required retirement lifestyle.”
The state pension rises to 67 between 2026 and 2028, and the age of which you can access your pension will also rise, to 57 in 2028.
This will apply to the tax-free cash, too, said Stephen Lowe, director at retirement specialist Just Group. “Earlier access may be allowed for serious ill health while some schemes have protected pension ages that allow you to get at your money before age 55, so check if that applies to you.”
Lowe said anyone thinking about accessing their pension should consider taking the free and impartial guidance on offer from the government-backed Pension Wise service. “Many will also benefit from independent financial advice.”
Having early access to your money is a double-edged sword, he added. “It can help fulfill your dreams, gift money to family or see your through periods of illness or unemployment. Yet the remaining funds must sustain you through retirement, which at 55 could run for another three decades or more.”
Lowe said the big question to ask yourself is “Why do I need the money?”. “The longer you leave it, the more time it has to grow.”
