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Since 6 April 2015, the “Pension Freedoms” have allowed UK taxpayers to withdraw up to 25% of the value of their pension pot(s), tax-free, from the age of 55. Yet is it a good idea to take this amount out of your pension? There are pros and cons to weigh up, and it often helps to get help from a financial planner. Ultimately, the decision depends heavily on your financial goals, your unique circumstances and the nature of your pension(s). Below, our Burnley financial planners outline some of the main considerations to weigh up on each side.
Your 25% tax-free lump sum: reasons in favour of taking it
Perhaps the biggest advantage of your tax-free lump sum is that it is free of tax! Suppose you have £200,000 saved in a personal pension. After age 55, you could conceivably take £50,000 out without needing to worry about tax erosion. Another benefit is that you can have immediate access to much-needed funds. If you have a costly debt to settle (e.g. an unpaid credit card), or if you wish to make a home improvement or pay down your mortgage, then your 25% tax-free lump sum can be useful. A third advantage is flexibility. Only a few decades ago, pension savers were forced to use their pension funds to buy an annuity (if they did not have a defined benefit pension). Today, however, individuals have far more choice over how to use their pension funds. You could buy an annuity with some of your pension, for instance, whilst keeping the rest of it invested. Some of your money could be taken as a lump sum, or kept entirely in your pension pot. In short, the Pension Freedoms have opened up more options for retirees since 2015.
Reasons to not take your 25% tax-free lump sum
Taking your 25% lump sum is not a decision that should be taken lightly. There are risks to take into account. A financial planner can help you consider these carefully with the best information available. In particular, taking a large tax-free lump sum from a pension can reduce your income later in retirement. To make up the shortfall, you may need to consider working longer or relying on other income sources to sustain you in retirement (e.g. buy to let income). The second issue is accessibility. Once you use your tax-free lump sum, you cannot use it again. Therefore, you must be very confident that you will not need the option in the future. A third potential issue is how to best commit the 25% tax-free lump sum. For instance, it might seem sensible to take the money and pay down your mortgage. Yet there is a risk that this incurs an opportunity cost (i.e. if the mortgage interest savings are unlikely to beat the returns you could realistically expect to generate by keeping the money invested in your pension).
The tax-free lump sum and wider financial planning
Taking your tax-free pension lump sum is not an isolated decision. It can have wider effects on your financial plan (which is why it is helpful to seek advice). In the background, for instance, there is inheritance tax (IHT) to consider. In 2022-23, defined contribution pensions (pension “pots”) can be passed down to beneficiaries, upon death, without IHT. If you plan on leaving a meaningful legacy to your loved ones in the future, therefore, then you may wish to limit – or avoid – taking your 25% tax-free lump sum, as this could increase the amount of wealth that you could pass down to your family.
Conversely, taking your tax-free lump sum could be a better option than, say, moving pension pot money into flexi-access drawdown and starting to take an income (alongside your salary). Doing this will trigger the Money Purchase Annual Allowance (MPAA) rules, which limit how much you can contribute to your pension(s) each tax year; down from a maximum of £40,000 to £4,000. Generally, however, taking your tax-free lump sum does not trigger the MPAA rules. So, if you really need money from your pension soon, then this option might be better than options which trigger the MPAA (although seek professional advice first).
It is important to remember that not all pension schemes offer a UFPLS (uncrystallised pension lump sum). So, check with your provider first. Certain providers may limit how often you can make lump sum withdrawals, such as once or twice per year. They might even impose a charge in certain circumstances, so check the fine print carefully. Also, bear in mind that the UK tax system has an unfortunate quirk which can lead to emergency tax on your first pension lump sum withdrawal. This is because your pension company may not know your tax code. HMRC should eventually pay any excess tax to you (e.g. at the end of the tax year), but it will be your responsibility to check this and pursue the matter if it is not resolved.
Invitation
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938
E: info@elmfieldfp.co.uk
