The 25% tax-free lump sum is one of the most popular pension benefits. It feels like a one-off retirement bonus and can go towards the holiday of a lifetime, paying off your mortgage or helping children and grandchildren — but taking it all isn’t necessarily best for your finances long-term.

One of the most important things to think about when taking tax-free cash is whether you really need to do so. It can be very tempting to take it in one go but this should only really be done if you have a specific reason, otherwise you potentially risk leaving yourself financially stretched later in retirement. If you have a defined contribution pension (a “pot of money” pension, where what you get in retirement depends on how much you pay in and your investment growth), you can access your pension from age 55, increasing to 57 in 2028. You can decide how much you take from your pension each time. When you do this, it is known as “crystallising” some of your pension. Each time you crystallise part of your pension, you can take 25% as tax-free cash and then choose what to do with the other 75%: buy an annuity (an insurance product where you swap a lump sum for a guaranteed retirement income) or move into drawdown (a pension product where your money stays invested and you can withdraw an income). You could also take it all as cash, but any money outside of your 25 per cent tax-free lump sum would be taxed as income. If you want to take all of your tax-free cash, you would need to crystallise your whole pension pot. For example, if you have a £400,000 pension pot, you would need to crystallise the whole pot, taking £100,000 of it as tax-free cash and using £300,000 to buy an annuity or go into drawdown. But you do not have to crystallise your pension pot all at once and, if you don’t need to take the whole tax-free lump sum, it could be tax-efficient to take your tax-free cash little by little. Say you want to take £20,000 a year from your pension in retirement. If you have already crystallised your whole pension pot and spent your 25 per cent tax-free lump sum, you will be withdrawing the £20,000 a year from your drawdown pot. You will get £12,570 of it tax-free (the personal allowance), and you will pay basic rate income tax of 20 per cent on the remaining £7,430. This leaves you with a yearly tax bill of £1,486. But if you have not yet taken your tax-free cash and left your pension uncrystallised, you can crystallise the £20,000 you need each year. As you have not used any of your tax-free cash, 25% (£5,000) will be completely tax free. The remaining £15,000 will be taxed as income. You will get £12,570 of this tax-free thanks to the personal allowance, and you will therefore only pay basic rate income tax of 20% on the remaining £2,430. This leaves you with a yearly tax bill of £486. Another benefit of leaving some of your pension uncrystallised is that you could end up with more tax-free cash in the long run. If you have a £400,000 pension pot and take 25% (£100,000) as a tax-free lump sum, then this £100,000 is the maximum tax-free cash you will get. But if you only crystallised £20,000 of your £400,000 pot (and took £5,000 as tax-free cash), there would be £380,000 left. If this £380,000 grew by 4% through investment growth in the first year, it would grow to £395,200. You could then take another £20,000 (and another £5,000 of tax-free cash), leaving £375,200. If this grew by 4% again in the second year, it would grow to £390,208. At this point, you have already taken £10,000 of tax-free cash. If you then decided to crystallise your whole pension pot, you could take 25% tax-free cash of the total (£97,552), giving you a total tax-free cash of £107,552.

Things to consider:

There are plenty of good reasons to take your tax-free lump sum. If you have any credit card debt or a mortgage, it can be financially and emotionally good to pay this off. Many people also like to see their financial gifts to children and grandchildren put to good use while they are still around to see the benefits, so it could be worth using your tax-free cash to help your family members — but only if you can afford to do so, and it won’t affect your living standards in retirement. In most cases, once you access your pension your annual allowance (the amount you can pay into a pension each year) drops from £40,000 to £10,000. This means you should be certain that you do not need to continue contributing significantly to your pot when you take your tax-free cash. And if you do not think you will use all of your pension savings in retirement, remember that pensions are usually not classed as part of your estate, and are therefore free from inheritance. This means that if you do not need the money, pensions can be a tax-efficient way to pass on wealth.

Financial Advice Including Pension Advice, Bristol
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