7 things to consider before taking cash from your pension

Important information -  investment values (and income from investments) can go down as well as up, so you may get back less than you invest. SIPP eligibility and tax treatment depends on individual circumstances and tax rules may change. Before transferring a pension, compare all the benefits, charges and features and always seek financial advice if you’re unsure.

By Ed Monk

Many people look forward to the moment when they can at last get their hands on the money that they’ve saved over the years inside a pension.

Often the first port of call is the 25% of a pension pot that the rules usually allow you to take tax-free, currently from age 55 (57 from 2028).

But rushing into that decision comes with no small amount of risk. There are a few things you need to know about before taking your cash lump sum. As a start, it crystallises your pension pot. This is pension speak but it simply means that once you take income or tax-free cash from your pension you can no longer take any further tax-free cash from that part of the fund meaning you can no longer build up any further entitlement to tax-free cash.

1. What will you do with the money?

It can sometimes feel as though money inside a pension only becomes real once you’ve withdrawn it and brought it into the ‘real world’. That’s perhaps why most people choose to access their tax-free cash as soon as it becomes available - currently from age 55 although that limit, known as the ‘Minimum Pension Age’, is due to rise to 57 in the coming years.

But it is important to understand the implications of that decision. Money that remains inside a pension enjoys some advantages in the tax system. If you withdraw tax-free cash and place it inside a savings account or other investments, any returns it earns could be subject to tax whereas it would have grown tax-free in your pension. You may be able to rehome your tax-free cash inside an ISA to avoid this, but what you can pay in is limited, currently to £20,000 a year.

What’s more, the bank deposit will be included in your estate for inheritance tax purposes (more on that below), whereas it is exempt from inheritance tax while in a pension and having additional assets in a bank account may affect your ability to claim certain state benefits.

That means taking tax-free cash should only be done if you have a good reason. There are plenty of reasons why it may still be a good idea - if you want to pay off debt, or perhaps help grown-up children to buy a house, for example - but withdrawing it to simply sit on it may not work in your favour.

And remember, you don’t have to take the whole 25% that is available, you can simply take out what you think you’ll need and leave the rest.

2. What will be the impact on your income in the future?

The money in your pension is primarily there to provide income for your retirement. That may be by using it to purchase an annuity or by taking an income flexibly via drawdown or in lump sums - you can read more about retirement income options.

By taking out 25% of your pot you will be reducing your pot’s ability to generate income in the future. Furthermore, by doing so when you may still have many years before you retire completely from work - you are removing the opportunity for that money to grow in value via investment returns, although that is not guaranteed and your money could lose value.

Consider that 25% of £80,000 amounts to a tax-free lump sum of £20,000 but 25% of a fund that has grown to £100,000 provides a tax-free lump sum of £25,000, which means £5,000 more of the fund is available tax-free.

You could get an idea of the impact of withdrawing tax-free cash by using online calculators. Fidelity’s Pension Tax Calculator allows you to enter the value of your pot, when you plan to take it and the level of tax-free cash you plan to take, to show you the impact on your likely income in retirement.

3. Do you expect to pass money on to loved ones?

Passing on an inheritance to family and loved ones is an aim for many people. Those with significant wealth run the risk that the money they leave is subject to Inheritance Tax (IHT). Pensions normally fall outside your estate and aren't typically subject to IHT.

That could be a reason to leave it where it is if you can meet your financial goals another way. Read more on passing on wealth.

4. Is now the best time to withdraw from your invested pension pot?

If you don’t need the money right away and have some flexibility about when you take your tax-free cash, try to avoid taking it immediately after investments in your pension pot have suffered a heavy loss.

Don’t sweat over small market movements, but if there has been a big market fall you risk locking in those losses before your pot has had a chance to recover.

If you have a very large pension pot, upward market movements might take your savings above the ‘Lifetime Allowance’. This is the total amount you can build up in pension benefits over your lifetime while enjoying full tax benefits.  

5. Should I bring my pensions together?

It’s likely, over your working life, you’ve built up several pension pots. Although you can manage the retirement income and the tax-free cash from each of these pensions separately, it can be a lot easier before accessing your pension to bring these together into a Self-Invested Personal Pension (SIPP). This way, you only have one company to deal with for every aspect of your retirement income and you could save on costs if our service fees are less than you’re currently paying. Also, you’ll be able to see more clearly how much you have and where your money’s invested, enabling you take any actions needed to ensure you have a good balance of investments, appropriate to your life-stage and how you’re looking to access your pension.

Before transferring though, one of the most important things to check is whether any of your existing pensions contain valuable benefits that will be lost if you transfer away. For example, final salary pensions, guarantees of income or investment returns, early retirement options, a greater entitlement to tax free cash than the standard 25%, life insurance, to name a few. If this is the case then it’s likely that it won’t be in your best interest to transfer, and it’s essential you receive financial advice if you still want to proceed in order to make an informed decision.

Also, if any of your pension pots are under £10,000, then you may be able to take it all as a ‘small pot lump sum’ with your existing provider. You can usually take the tax-free part as normal with the balance taxable at your highest rate of income tax. Taking your money in this way doesn’t trigger the lower money purchase annual allowance that restricts tax relief on your future contributions to £10,000. So, if you transfer such small pots into one account which then exceeds £10,000 the option of taking it all as a small pot lump sum could be lost.

6. Could you benefit from some help?

Planning your retirement finances is not always straightforward and balancing the benefits of different courses of action can be difficult without the help of professionals.

Thankfully, there is plenty of help at hand. The Government's Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or call them on 0800 011 3797.

Fidelity’s retirement specialists help people in this position everyday.  They can provide you with specific advice based on your personal circumstances for a fee but also free guidance if you wish to make your own decisions.   Not sure what's right for you? Call us on 0800 368 6891. We’re available Monday to Friday, 9am - 5pm. 

7. What will you do with the money that’s left in your pension?

Deciding to withdraw tax-free cash is not the only decision you need to make - you must also decide what to do with the money that’s left inside your pension.

The appropriate course of action will depend on your wider financial circumstances and your plans for the years ahead. If you take financial advice, you’ll get an investment strategy that is aligned to your needs.

On the other hand, if you choose to do it yourself, you’ll need to select your own investments. ‘Investment Pathways’ is one way that might help - designed to ensure that anyone with a pension account can have access to investments that broadly match a range of goals.

Investment Pathways works by asking a few questions about your future plans for your pension pot: Do you wish to leave your money untouched for the next five years? Do you plan to take all your pension money out within the next five years? Do you plan to set up a guaranteed income via an annuity? Do you plan to start using your money to provide a long-term flexible income?

By answering these questions, you’ll then be shown the Investment Pathways fund that most closely matches your plans. You don’t have to choose this fund - you can pick any fund or a combination of funds - it’s up to you.

Another question is what contributions you want to continue to make to your pension. If you take taxable withdrawals from a pension you are usually then limited in what you can pay in after that. This limit is known as the ‘Money-Purchase Annual Allowance’ and is currently set at £10,000 - way below the Annual Allowance cap of £60,000 for pension contributions (which is 100% of your earnings if you earn less than this, or to £3,600 if you have no earnings).

Important information: tax treatment depends on personal circumstances and all tax rules may change in the future. You cannot normally access money in a pension until age 55 (57 from 2028). It’s important to understand that pension transfers are a complex area and may not be suitable for everyone. Before going ahead with a pension transfer, we strongly recommend that you undertake a full comparison of the benefits, charges and features offered. To find out what else you should consider before transferring, please read our transfer factsheet. If you are in any doubt whether or not a pension transfer is suitable for your circumstances we strongly recommend that you seek advice from one of Fidelity's retirement specialists or an authorised financial adviser of your choice.