Whatever you want to do with your retirement fund, there are important things you must know before making a big withdrawal from your pension pot.
The pension freedoms – introduced back in 2015 – revolutionised the way we access our retirement savings.
All previous restrictions were removed, and from the age of 55 (rising to 57 from 2028) we can now start taking money out of our pensions whether or not we have retired or started winding down from work.
At the time, a government adviser famously said you could treat your pension like a bank account, and the move has certainly made it easier for over-55s to access lump sums.
And it’s certainly proving popular. According to Financial Conduct Authority (FCA) statistics, in 2021-22 there was a 28% increase in the number of over-55s who made a withdrawal from their pension, without then buying an annuity or going into drawdown.
A lump sum from your pension could be used for anything from helping out children or other family members, paying for work on your home or simply treating yourself. Alternatively, as the cost-of-living crisis rumbles on you might have some unexpected expenses to deal with, or decide you would like to pay your mortgage off in the face of rising interest rates.
But while the pension freedoms have certainly increased options for over-55s, viewing any of your various pension pots as a ready source of cash, before you need retirement income, could be a dangerous course to follow.
Check out our guide to everything you need to know about taking lump sums from your pension before you retire.
Pension lump sums are tax free, right?
A longstanding – not to mention popular – feature of UK pensions legislation is the ability to take up to 25% as a tax-free lump sum, formally known as your pension commencement lump sum (PCLS).
But the important point to note is that this can only happen at the point that you ‘crystallise’ your pension, which is when you start taking your retirement benefits. It means you will eventually have to decide whether to move the rest of your pot into flexi access drawdown or buy guaranteed income with an annuity.
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If you aren’t doing either of these things and simply want to take a lump sum out of your pension and leave the rest of it invested, it will be classed as an ‘uncrystallised funds pension lump sum’, or UFPLS, and the tax treatment will be different.
Uncrystallised funds pension lump sum is potentially the most extreme example of unnecessary pensions jargon. But it essentially means a withdrawal from a fund that hasn’t yet been assigned to drawdown or used to purchase an annuity (crystallised).
How much tax will I pay on my UFPLS withdrawal?
Unlike tax-free cash - or PCLSs - only the first 25% of any UFPLS withdrawal will be paid tax free.
The remaining 75% will be added to your overall income for the year and taxed at your marginal rate – the highest rate of tax you pay.
It’s worth noting too that this additional ‘income’ could be enough to bump you into a higher tax bracket. This could mean you become a higher or additional rate tax payer overnight and pay more tax on your pension withdrawal than you’ve paid on your earnings throughout your working life.
Another unfortunate side-effect of your withdrawal is that, if it’s your first withdrawal on your pension, you’ll also be hit with emergency tax.
This should be repaid to you by the end of the tax year, or you can get it back faster by submitting a claim direct to HMRC.
Other important considerations
Another tax point to consider is that once your money has been taken out of your pension, it will no longer be sheltered from inheritance tax.
Your money might not be as easy to access as you imagine either. You might have to pay an exit fee to access your money (capped at 1% for over-55s) or, especially with older schemes, find that withdrawals are restricted. For easy access to your savings, you might need to switch to a more flexible provider.
Finally, and by no means least, is that when you make an UFPLS withdrawal, the amount that you can then pay into your pension going forwards will be cut from a maximum of £60,000 to just £10,000.
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This is the money purchase annual allowance (MPAA), and it replaces the annual allowance once you have started making taxable withdrawals from your pension. The only exception is if you are cashing in all of a scheme worth less than £10,000, under the ‘small pot’ rules.
Under the MPAA, you will also lose the ability to carry forward any unused annual allowance from the three previous tax years.
This all means that triggering the MPAA could severely hinder your ability to grow your pension in the final years of your working life – especially if you’re a higher earner or want to pay bonuses or other windfalls into your retirement pot.
Should you take a lump sum out of your pension?
As convenient as it might seem to take money out of your pension when you need to raise a lump sum, it’s important to weigh up the benefits with the tax that you will pay on your withdrawal.
Normally it makes more sense to take money out of accounts such as ISAs, which will not hit you with a tax charge when you make your withdrawal.
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When that’s not an option, there might be some cases where it makes sense taking money out of your pension, for example an emergency or to pay off a debt such as a mortgage. However, it’s important to weigh up the benefits against the tax bill.
Whether you are cashing in all of a smaller pension or a chunk of a larger one, it’s also important to bear in mind that you are reducing the amount of money you’ll have to live on when you retire.
Taking money out of your pension will reduce its growth potential and the eventual income your pot will be able to generate. That means you’ll need to think whether you’ll have enough left to generate a sufficient retirement income, or if you’ll have income from other sources.
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