3 options for taking pension tax-free cash

How to avoid any cut in tax-free cash – without losing out if it doesn’t happen

If everyone knows about tax-free cash and intends to take it, rather fewer will understand in detail how it works – and how that detail can help them plan for contingencies such as a change in the rules.

There are several ways to take tax-free cash and this gives savers a great deal of flexibility.

You can of course simply take 25% of your pension tax free in one go, as long as you have reached the age of 55 (57 from 2028). The other 75% can be left to grow inside the pension or taken immediately, in whole or in part, although tax would be due.

The next option is to take just some of your tax-free cash. In this case, the pension pot is notionally divided in two and you are deemed to have taken 25% of one of the portions. The remaining 75% of the portion from which you took tax-free cash is available to withdraw as before while the untouched other portion will be left to grow inside the pension.

That may sound complex so here’s an example. Imagine you have a £100,000 pension pot and want to withdraw £10,000 as a tax-free lump sum. That £10,000 is 25% of £40,000, so the pot is divided into one portion of £40,000 and one of £60,000. As far as the £40,000 portion is concerned, £30,000 is left after you have taken the £10,000 tax-free cash and can be left alone or withdrawn, subject to tax, as above. The £60,000 portion is left inside the pension to grow and will be available to withdraw, a quarter of it tax-free, at a later stage. This process can be repeated as often as you like.

A variation on this is to take a series of withdrawals, each of which consists of 25% tax-free cash and 75% of taxable cash. This can be achieved via a process that goes by the unpalatable name of UFPLS (uncrystallised funds pension lump sum).

This flexibility gives savers worried about any Budget attack on tax-free cash a couple of options. One is that they could simply hedge their bets and take, say, half of the tax-free cash available, or 12.5% of their pension savings. If in the end the Chancellor does nothing, they will have the other half available to withdraw in future.

Another is taking as much tax-free cash as they could put into ISAs within, say, this tax year and next, using their own allowance and that of a spouse or civil partner and also perhaps the £9,000-a-year Junior ISA allowances of any children. A married couple with two children could contribute a total of £58,000 in the current tax year to ISAs and the same when the new tax year begins next April – £116,000 in all.

The tax benefits of ISAs at this point are the same as those on pensions, because the money transferred to the ISA will already have benefited from upfront income tax relief – the principal advantage of pensions over ISAs – when it was contributed to the pension. No tax is due when the tax-free lump sum is withdrawn or when it is put into the ISA, and both ISAs and pensions offer tax-free growth from that point onwards.

To prove the point, imagine you currently have a £100,000 pension and are tempted to take the tax-free cash now in case Ms Reeves does change the rules in the Budget. You take out your £25,000 tax-free lump sum and invest it all in ISAs, using exactly the same investments that you have in your pension.

Let’s imagine that over the next 10 years those investments double. If you had left the entire £100,000 in the pension, it would be worth £200,000, which would give you a tax-free lump sum of £50,000 and a further £150,000 in the pension available to withdraw as taxable income. If you had instead taken out £25,000 tax-free before the Budget and invested it in ISAs, that money would have grown to £50,000 in 10 years’ time and the £75,000 that was left inside the pension would have increased in value to £150,000, which would be available to take as taxable income. The outcome is identical in either case.

If you withdraw more in tax-free cash from your pension than you can invest in ISAs, however, you will pay tax on investment gains that you wouldn’t have paid had the money remained in the pension. Here the decision is a balancing act between the fear of a punitive raid on the lump sum in the Budget and the forfeiting of future tax-free growth.

A saver who withdraws more than they can put into ISAs and then finds that the Chancellor does nothing would be left out of pocket; accordingly, some experts advise caution. Some financial planners are known to be uncomfortable about taking any action based on speculation surrounding the Budget.

If you are in doubt, it may be best to seek help. The government’s Pension Wise services 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.

Taking some of your tax-free cash before the Budget will not help you if the Chancellor decides to cut the lifetime allowance for the lump sum (the amount you have left to withdraw in future will decline in line with the new, lower limit), unless the amount you take now exceeds any new lifetime allowance. A pre-Budget withdrawal could however be to your advantage if Ms Reeves decided instead to cut the 25% figure to, for example, 20% (assuming that the change was not retrospective).

One important thing to watch for when you take money out of your pension is the potential effect on your ability to contribute to it in future. Normally you can pay up to £60,000 into your pensions in one tax year but this allowance falls to £10,000 once you have made any withdrawal other than tax-free cash. (Annual allowances can be lower than those figures if you have a very high income.) More details about how this all works can be found in our guide here. There are also rules about ‘recycling’ money into a pension.

Remember too that money in a pension is protected from inheritance tax but money in an ISA is not. If your priority is maximising the amount you can leave tax free to your heirs, it may be better to leave all your money inside the pension.

It’s also important to note that not all pension companies offer all the options described above, so you might need to switch your money to another provider first. If you do decide to withdraw some of your tax-free lump sum, you should receive it within days.