Whether you want to pay off a mortgage, go on the holiday of a lifetime, or reach a lifestyle goal that requires a larger lump sum of money – withdrawing a large chunk of cash from your pension, tax-free, can often help you achieve that.

But have you considered how it actually works, and how it can affect your future income?

Under the current pension system, from age 55 (rising to 57 in 2028) – a number of years before most people will actually stop working – pension rules generally allow for up to 25% of the value of a pension pot to be withdrawn, free from income tax.

There are different ways to take the tax-free cash from your pension, and the most suitable option for you will depend on a variety of factors, such as whether you need to access the cash straight away and your plan for generating future income.

So, how does the tax-free lump sum work?

When you take money from your pension, most of it will be taxed at your income tax rate, but the Pension Commencement Lump Sum (PCLS) allows you to take up to 25% tax-free if you have a defined contribution pension. The rules surrounding your PCLS will depend on your pension provider and the type of pension you have.

The tax-free cash can only be taken at the point of ‘crystallisation’ where your pension is accessed in order to provide retirement benefits. The PCLS can be taken as one lump sum or as a series of smaller sums until you hit the 25% limit.

Take all or part of the tax-free cash

You may decide to withdraw the tax-free cash (25% of your pension pot) and leave the rest in your pension to either provide an income now or to grow tax-free.

  • Move your pension into drawdown: If you want to take your tax-free cash but don’t need to take any income from your pension, a drawdown may be suitable. With drawdown you receive the 25% tax-free cash and keep the rest invested as you choose. You then make withdrawals, which will be taxed as income, directly from the remaining funds whenever you are ready.
  • Buy an annuity: Another option is to take the 25% tax-free cash and use the rest to buy an annuity. An annuity provides a guaranteed annual income that will be paid to you for the rest of your life. In this way, the money remaining in your pension after the tax-free cash is taken is exchanged for a regular and secure income. The income from the annuity will be taxable and how much income you will receive will depend on different factors such as your age, pension value and the rates available at the time.
  • Take lump sum withdrawals: You could also take lump sum withdrawals, as and when you need to where 25% of each withdrawal is paid tax-free and the rest is taxed as income.

Consider the impact on your future income

With both drawdown and lump sum options you need to consider how long you need your pension to last, as if you withdraw too much money too quickly, there is the possibility that you could run out of money.

With an annuity, your income is guaranteed, but this is not the same with drawdown and lump sum options. To add to this, you will need to regularly review your investment choices and be aware that whilst drawdown investments may grow, they can also go down and you could get back less than you originally invest. The risks involved mean that drawdown and lump sum options won’t be right for everyone.

You may wish to withdraw your whole pension, including the tax-free cash as one lump sum. However, if you take your pension in one go you will need to consider whether you have enough money left to provide an income to fund your retirement.

In the UK, the population is getting older, and life expectancy is also increasing, meaning older workers may now face the possibility of spending more than 30 years in retirement, which many people do not plan for.

For this reason, it is key to plan for different eventualities, as there is no way to predict how long you will be in retirement, and in good health.

Put a plan in place for your tax-free cash

If you don’t need to access the money straight away, the best option would be to keep the money in your pension where it can grow tax-free.

If you were to take the money out of your pension and put it into a bank account, any returns it earns could be subject to tax. Alternatively, you could put the money into an ISA, tax-free, but the amount you can pay in tax-free is limited to £20,000 per tax year.

The money is also exempt from Inheritance Tax (IHT) whilst it is in a pension but would be included in your estate for IHT purposes if deposited in a bank account or ISA. Additional assets in a bank or savings account can also affect your ability to claim certain state benefits.

Overall, it is a good plan to only take the amount of tax-free cash that you need at the time, leaving the rest in your pension to grow tax-free, so you could end up with a greater tax-free sum overall.

Retirement planning specialists

At Smith Cooper Independent Financial Solutions, we always recommend that you consider planning for retirement as soon as you can.

The main aim of retirement planning is to ensure that your accumulated wealth can provide a sufficient level of income in retirement. Optimising your pension to suit your individual objectives is key to planning for and generating retirement income.

Our team of dedicated chartered financial planners can help you to realise your retirement ambitions, working with you to devise an individual financial plan that considers cash flow requirements and investment opportunities alongside your short, medium and long-term objectives.

If you would like to arrange an initial discussion on pension planning or retirement planning with one of our chartered financial planners, please do not hesitate to get in touch.

Please note: A pension is a long-term investment, the fund value may fluctuate and can go down. Your eventual income may depend upon the size of the fund at retirement, future interest rates and tax legislation.

Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from taxation, are subject to change.