How to make the right decision on taking pension tax-free cash

The 25% tax-free lump sum you can take from your pension will be left alone in the Budget, Treasury officials have reportedly said. But it remains to be seen if savers will be sufficiently reassured by the reports to leave their pension pots untouched; many have been taking their lump sums in recent weeks in fear that the Chancellor would impose new limits on the tax-free withdrawals.

The Telegraph reported on Tuesday that Rachel Reeves had decided against new restrictions on the tax-free sum, such as a £100,000 cap. The newspaper said: ‘Treasury officials confirmed to The Telegraph that Ms Reeves will not make any cuts to the limit on Nov 26 [Budget day].’

Savers had faced a tricky dilemma: should they withdraw the tax-free cash from their pension before the Budget and risk exposing it to future taxes needlessly? Or should they leave it where it was and risk the Chancellor cutting the limit, leaving them with less tax-free cash than before?

The settled view of the finance industry is that it’s better not to act on the basis of speculation, but some savers had been voting with their feet and taking their tax-free lump sums before the Budget. We are not saying investors would be automatically wrong to do so; however, it is vital to think carefully about your options and to avoid acting without a plan.

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Perhaps the first thing to do is put the danger in proportion. It is perhaps not widely appreciated that there is already a cap on the tax-free lump sum, at £268,275, which is 25% of the now-abolished £1.1m lifetime allowance for pension savings. If that £268,275 limit were cut to £100,000, as several groups have advocated, the reduction would amount to about £170,000.

As Fidelity’s Tom Stevenson has pointed out, a retired saver who managed his withdrawals to avoid the higher-rate tax band would face an extra £34,000 in tax on that £170,000. Yes, £34,000 sounds like a worryingly large sum but it is just 3.1% of a £1.1m pension pot and the kind of percentage change easily dwarfed by stock market movements. 

‘I would argue that the more pressing imperative for an investor with a big pension is not to second guess an unpredictable political decision but to ensure that their investments are future proofed against market risk,’ Stevenson said. ‘A bear market would have a much bigger impact on the value of your retirement savings than tinkering by a cash-strapped government.’

Let’s put it another way: should the tax-free allowance be cut to £100,000, anyone whose pension pot is worth £400,000 or less will be unaffected. And for every extra £50,000 in the pot, the tax hit could be as little as £2,500 (20% of tax on the 25% formerly tax-free element).

If, despite the arguably limited impact of any change and the new reports that the Chancellor will do nothing, you still feel uneasy and would like to protect at least some of your tax-free lump sum by withdrawing it before the Budget, remember that you can put £20,000 of any tax-free cash you withdraw straight into an ISA. Double if you are a couple. And double again – £80,000 in total for a couple – if you use this year’s allowance and next year’s, which you can do on 6 April (you could hold the money in a general investment account until then). On top of that, if you have children you may be able to use the £9,000-a-year Junior ISA allowance. This does of course assume that you and your family have not yet used this year’s ISA allowances.

Within your ISA or general investment account you could invest the money exactly as you had within the pension. In this way your eventual returns would be completely unaffected by the withdrawal from the pension because ISA money and the tax-free element of pension savings are equally protected from future tax.

There’s a further case in which taking some or all of your tax-free cash before the Budget is not a risky move. This is if you had already decided to withdraw it before long and are merely bringing the withdrawal forward to forestall any move by the Chancellor. There are plenty of good reasons for taking tax-free cash in this way, such as paying off a mortgage or other debt, funding a career break or a child’s education or helping your offspring on to the housing ladder.

• Read: What can we expect in the Autumn Budget?

What we would caution against is withdrawing your tax-free cash with no such plan for its use and when you cannot put the money into an ISA. That way you would run the risk of regretting the move (which is irreversible) and then having to decide what to do with the money – or even finding it burning a hole in your pocket, to the detriment of your eventual income in retirement.  

Wanting to protect your pension savings from tax is a perfectly natural reaction to all the pre-Budget speculation. What’s critical is to be aware of the risks involved in doing so and to weigh them up rationally against the potential costs of doing nothing. Above all make sure you have a plan that covers all eventualities before you act.

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 specialists can provide you with guidance to help you with your decisions. They can also provide advice and help you select products, though this will have a charge.

• Read: Don’t cash you pension lump sum until you’ve read this
• Read: 8 questions before you take tax-free cash from your pension
• Read: 5 good reasons to take your tax-free cash - and 5 bad ones

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 and tax treatment depends on individual 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). 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.