Important information - the value of investments and the income from them can go down as well as up, so you may get back less than you invest.
You can take a quarter of your pension savings tax free: everyone knows that. Far fewer, one suspects, realise quite how much flexibility you have about exactly how, and when, you can take that 25% lump sum.
And while some will think it’s better not to make investment decisions on the basis of speculation, those worried about possible changes to the rules in the Autumn Budget later this month could turn that flexibility to their advantage.
Here we look at the various options for taking your 25% tax-free lump sum from your pension – and how those options might help you prevent damage to your savings should the Chancellor make any changes on 30 October.
How likely is Labour to cut the tax-free lump sum?
The party’s only explicit tax promise, during the election campaign and in its manifesto, was not to increase income tax, National Insurance or VAT. Labour has also made vaguer statements to the effect that it won’t raise taxes on ‘working people’. Tightening the tax breaks on pensions, particularly for richer savers, could therefore be one way for Rachel Reeves to help plug the £22bn ‘black hole’ she says she has discovered in this year’s public finances.
One option for her would be to limit the total that can be taken tax free from a pension. Currently the most that most pension savers can take as tax-free cash over a lifetime is £268,275 (the strange figure arises from its origin as a quarter of the lifetime limit on pension savings in force when that limit was abolished). That £268,275 figure is a very large sum of money and the Chancellor could credibly argue that no ‘ordinary working person’ would ever be in a position to take it, since it would require a pension pot of more than £1m. It’s hard to imagine her inciting widespread anger if she decided to cut the lifetime limit on tax-free pension withdrawals.
She could, for example, limit the lump sum to 25% of the pension pot deemed necessary to give a saver a decent standard of living in retirement. According to Standard Life, the insurer, the sum required is £278,000 for a married person, from which the tax-free lump sum would be £69,500. But a single person needs £555,000, which would mean a lump sum of £138,750.
The Institute for Fiscal Studies (IFS), the respected research group, called in February last year for reform of the tax-free lump sum. It said that, ‘at the very least’, it should be capped at £100,000 because the richest savers benefited most from it. The Fabian Society, a Left-wing think tank, echoed this call last month.
But cutting the total amount that can be taken in tax-free cash over a lifetime is not the only change the government could make to the pension lump sum. It could, for example, reduce the 25% tax-free cash percentage to, say, 20%. Such a move, however, would affect almost everyone who has a pension: ‘the vast majority of pension savers will take 25% of their pension free of income tax’, according to the IFS. It could therefore be said that ‘working people’ would be among those affected and the Chancellor may choose to avoid the inevitable backlash, especially as Labour is still reeling from the reaction to the means-testing of the winter fuel payment.
Other alternatives for Ms Reeves could include limiting tax-free cash for those who pay the higher or additional rate of income tax, although such a move would be administratively complex and relatively easily avoided.
Any change to the tax-free lump sum would be deeply unpopular, although it is a perennial focus of pre-Budget speculation. One advantage for the government is that tax-free cash changes would generate tax revenue more quickly than other possible changes to the pensions regime.
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.
Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Eligibility to invest in an ISA or SIPP and tax treatment depends on personal circumstances and all tax rules may change in the future. Withdrawals from a SIPP will not normally be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. 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.
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