Interactive Investor

How to use your tax-free lump sum

30th November 2022 13:33

Faith Glasgow from interactive investor

Faith Glasgow explains three options for your tax-free lump sum and highlights possible tax traps.

One of the many benefits of saving into a pension is to do with the tax you’ll pay when you eventually come to access it, which you can do from the age of 55 (rising to 57 in 2028).

Because you’re likely (although not bound) to have stopped working or be on reduced hours by the time you want to draw on a pension, you may well be paying a lower rate of tax than earlier in your career when you were building it up.

Better still, though, if you have a defined contribution (‘pot of money’) workplace or personal pension – a SIPP, for instance – you’re entitled to take up to 25% free of tax.

If you’re a member of a final salary or salary-related pension scheme, the tax-free sum is set by the scheme.

That sum won’t impact on your tax bill in any way - for instance by affecting your personal tax allowance (currently £12,570).

There are a number of ways you can take the money, and it’s worth giving them careful thought because each option can have significant implications for subsequence choices around your pension.

1) Take just the tax-free cash

This way you can take up to 25% of the fund and leave the balance invested until you need it. You can take the whole tax-free chunk at once, but if it’s a large sum it may make sense to draw just what you need and come back for more as necessary.

Taking smaller chunks not only leaves as much as possible invested and (hopefully) undisturbed in its cosy pension tax shelter, but also avoids the risk of it ending up in an ordinary savings account where the interest earned may be taxed.

When you’re ready to use the taxable element, you then have the choice of either using it to buy an annuity or moving it into a drawdown account. From there, you can withdraw occasional lump sums or pay yourself a regular income.

Tax alert 1: take only tax-free cash if you plan to return to work and hope to continue building up your pension unrestrictedly. As soon as you dip into your taxable pension in any way, the so-called money purchase annual allowance (MPAA) automatically kicks in, permanently limiting your total annual pension contributions to £4,000, rather than the standard £40,000 cap.

2) Cash in the whole pension

The flexibility is also there to allow you to cash in the entire thing, in which case you will be potentially liable for income tax on 75% of it, depending on how much it is worth and what else you’ve earned in the tax year.

This is a popular option for small pensions - more than half of the 700,000 pensions accessed for the first time in 2021-22 were cashed in completely – but there are health warnings attached. First, it will reduce the money you have available to live off down the line in retirement.

Second, many people simply take the money out and stick it in a savings account. There’s an argument in the present economic environment that a savings account paying a decent rate of interest is preferable to market exposure, given this year’s volatility.

But if you’ve pulled out of the market, there is no way your fund can recover any losses suffered as and when sentiment improves. And again, interest earned could be taxable.

If you don’t have a specific plan for the cash, it’s generally better to leave any money you don’t actually need invested in its tax wrapper.

Tax alert 2: cashing in your pension can also lead to an unexpectedly large tax bill. The balance over the tax-free 25% will be added to your other taxable income and could push you into a higher tax bracket. If it results in your total income exceeding £100,000, you’ll start to lose your £12,570 tax-free allowance.

Tax alert 3: there is a further risk that you will be overcharged tax when you cash in your whole pot. That’s because your pension provider - which deducts tax from pensions through the application of PAYE, like an employer – won’t know the correct tax code and is likely to use an emergency tax code.

The difficulty is that one-off withdrawals may be treated as the first of a series of regular withdrawals – so the tax is calculated as if you were going to be receiving the same amount every month.

If this happens it should be repaid by HMRC at the end of the tax year, or you can apply for a refund online at gov.uk, using the P53 or P53Z forms.

3) Take ad-hoc lump sums from your pension

If you take this approach, clumsily known as Uncrystallised Funds Pension Lump Sum (UFPLS), you leave your pension invested where it is and make cash withdrawals as you need them. A quarter of each withdrawal is tax-free and you pay tax in the usual way on the 75% balance.

It’s only an option if you have not yet touched your pension (this is the  ‘uncrystallised’ element of the UFPLS name).

UFPLS enables you to spread out the pension tax burden more smoothly, as every withdrawal includes 25% free of tax. It also means that the remaining fund, including the tax-free element, can continue to grow in its pension wrapper; over the years, it’s therefore likely that the amount of tax-free cash you receive will be larger than if you opted to take the whole lot up front.

Alert: pension providers are not obliged to offer UFPLS as an option, and you may have to move your pot elsewhere if necessary. 

Other considerations

Whichever option you decide to take, there are a few other things to be aware of.

You can take money - including tax-free cash – from your pension once you’ve reached age 55. But while accessing your retirement cash may sound very appealing, it’s not generally a good idea to do so before you have to.

That’s partly because the longer your money is invested, the more it’s likely to grow, because of the power of compounding as earnings are reinvested and themselves generate earnings.

Compounding is a slow burner - it has relatively small effects in the early years of a pension, becoming more powerful as the value grows over time. Curtailing the fund’s ‘late stage’ growth can make a big difference to its final value.

At the same time, the earlier you start drawing on your pension, the longer it will have to last. Men aged 55 can expect to live another 29 years on average, and women another 32, according to the Office for National Statistics (ONS) calculator. But there’s a one in four chance of men living to 92 and women to 94. That means you could be reliant on your pension to see you through getting on for 40 years.

However, if you’re between jobs, need to take time out to care for a parent, or want to cut back working hours and supplement your income, say, the tax-free cash in your pension could be a godsend.

If you’re planning to return to work, then make sure you understand the rules on triggering the MPAA. If you start to dip into your taxable pension pot, then it will limit the amount you can pay into your pension in the future.

And finally, it makes sense to get financial advice before you start taking your tax-free lump sum. Most of us spend years paying into our pension pot and it’s important to get it right when it comes to using our pension in retirement.

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