Does unused pension tax-free cash grow with my investments?

Q. Assuming it is not reduced significantly in the Autumn Budget, I am unlikely to reach the full 25% tax-free cash lump sum pension allowance. If I take only part of the tax-free lump sum, I believe I am entitled to leave the remainder to take later. Does the value of my remaining allowance continue to increase in line with the remainder of the pension pot if it remains invested, or is the value of my tax-free lump sum set at the point I make the first withdrawal?

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A. You are absolutely right that you do not (generally) need to take your whole tax-free lump sum at once. So long as your pension scheme allows, you should be able to take it in stages.

The maximum amount of tax-free cash you can take from your pension each time you “crystallise” your pension is 25%, unless you have tax-free cash protection in your scheme. Crystallising your pension means turning your pot into income, e.g. by buying an annuity or moving it into drawdown.

The total amount of tax-free cash that you can take over your lifetime is currently £268,275, but, again, this could be higher if protection applies. This is called your Lump Sum Allowance.

The important thing is that, if you do decide to take your lump sum in stages, you only crystallise as much of your pension as you need to get your desired amount of tax-free cash. This is crucial because, once you’ve crystallised pension money, if you don’t take the 25% tax-free cash at this time, you can’t go back and take it later.

Let’s look at an example: someone with a £400,000 pension, with a maximum amount of tax-free cash of £100,000 (25%). If they only want to take £50,000 of tax-free cash now and the rest later, then they should crystallise £200,000 of their pension now and take 25% of that as tax-free cash, giving £50,000 tax-free.

If they had crystallised the full £400,000 but only taken £50,000 (or 12.5%) as tax-free cash, they couldn’t go back later and take more tax-free cash because their pot is now fully crystallised.

If you only crystallise part of your pension and the value of the remaining amount continues to grow, then the value of the tax-free lump sum you can take on what’s left continues to grow too.

Taking that same example of the £400,000 pension, let’s assume the £200,000 left uncrystallised grows over the next five years to £250,000. They could still take up to 25% of this tax-free when they crystallise it, which would give a lump sum of £62,500.

The 25% tax-free lump sum is also referred to as the Pension Commencement Lump Sum (PCLS). This is different to taking income via Uncrystallised Funds Pension Lump Sums (UFPLS).

Under the latter, you can take money directly from your pension pot without moving it into drawdown first. Each withdrawal is treated as a mix of tax-free cash and taxable income.

With each UFPLS payment: up to 25% of the amount you withdraw is tax-free (depending on how much Lump Sum Allowance you have remaining) and 75% (the rest) is taxed as ordinary income in that tax year. You can take multiple UFPLS payments, so long as you still have uncrystallised funds left.

Let's look at that same £400,000 pension pot. Rather than taking the PCLS lump sum, the person could take a £25,000 UFPLS payment. Of that, £6,250 (25%) would be tax-free and the other £18,750 (75%) would be taxed at their marginal income tax rate, added to any salary, pension or other income for the year.

Their remaining pot is now £375,000 and still uncrystallised. They could take another UFPLS the following year, and again 25% of that payment would be tax-free, unless they’ve used up their full Lump Sum Allowance.

There are pros and cons to using both PCLS and UFPLS and which is better for you will depend on your personal circumstances and needs.

Please remember that this is not individual tax advice. Being tax-efficient in retirement is a complicated area and will depend entirely on an individual’s circumstances, so for many people it would be helpful to speak to a specialist tax adviser.

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 over the telephone on 0800 138 3944.

Fidelity’s Retirement Service also has a team of specialists who can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.

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Important information: - investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. Eligibility to invest in an ISA and tax treatment depends on personal circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.