As a result, ill-informed savers risk messing up their pension planning by failing to make the most of this opportunity to cut their HMRC bills.
Pensions tax-free cash, officially known as the pension commencement lump sum, would allow someone with, say, a £200,000 pension pot to withdraw £50,000 from age 55 entirely free of income tax.
That’s a remarkable benefit, potentially saving a basic rate 20 percent taxpayer £10,000 and a 40 percent higher-rate taxpayer £20,000.
For those who are in the know, it’s an unmissable opportunity.
Many build their retirement planning around it, say, by using the cash to clear their mortgage and other debts, or fund big-ticket items such as a new car, home improvements or dream holiday.
Yet 43 percent of over 55s remain unaware of the opportunity, rising to more than half of those aged from 50 to 54, new research from Standard Life shows.
Among those who do know, one in five have taken the money and one in 10 plan to do so, typically at the point of retirement.
A lot of people actively look forward to taking their tax-free cash and rightly so, said Dean Butler, managing director for retail at Standard Life.
Savers can have a lot of fun with the money but must plan ahead. “There are a number of key things to consider, notably whether to take it all in one go or split withdrawals into chunks.”
Taking tax-free cash “bit by bit” has two advantages, Butler said.
Firstly, the longer you leave your pension invested, the more time it has to grow in value. Second, by taking regular chunks you can keep a lid on your income tax bill for that year.
Any pension withdrawals you make on top of your 25 percent tax-free cash will be added to your total earnings for that year, and subject to income tax.
Too many pension savers fail to realise this and end up incurring a massive tax bill after taking a big chunk of pension in one year.
Some end up pushing themselves into a higher tax bracket as a result, with disastrous consquences.
Butler said there’s a way round this. “Using your tax-free lump sum to supplement the taxable part of your income could mean paying less to HMRC overall.”
Tax-free cash can also help smooth the path into retirement. A growing number dip into it while phasing into retirement by reducing their working hours. “You could use some of your tax-free funds to top up your reduced salary, for example, but without increasing your overall income tax bill.”
Another advantage of pensions tax-free cash is that withdrawing it will not reduce the amount you can pay into your pension plan in future.
In contrast, taxable withdrawals instantly cut the amount you can save into a pension to £10,000 a year, under the money purchase annual allowance (MPAA).
READ MORE: Pension withdrawals alert as thousands fall into HMRC tax trap – plan now
Beware taking your tax-free cash too soon as your pension savings need to last throughout retirement, which could be longer than you think, he advised. “You don’t want to run out of money later.”
If you leave you tax-free cash invested, its value will continue to compound and grow free of tax inside your pension.
If you are entitled to state benefits like Universal Credit or Pension Credit, cashing in too much pension could cut your entitlement, so check first.
The age of which you can access your tax-free cash is set to rise to 57 in 2028, to match state pension age increases.
If that age increase will affect you, make sure you plan around it.
In some rare cases you may be able to access your entire pension earlier, say, if you’re in poor health or belong to a scheme with a protected age.
Taking your pension money, whether your 25 percent tax-free cash or the remaining taxable 75 percent, is a big decision.
So consider getting financial advice or free guidance from government-funded Pension Wise.
Now you know the option exists, plan how to make the most of it.
