What can you do with your pension tax-free lump sum?

What can you do with your pension tax-free lump sum?

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    If you are over 55 (or not far off) and thinking about retirement, you may be wondering what you can do with your tax-free cash. Perhaps you have your eye on that new car, set of golf clubs or maybe you want to pay off your mortgage. But how exactly can you take your tax-free lump sum?

    You have many options when it comes to taking your pension tax-free lump sum. You can do nothing (without losing it), take smaller lump sums, opt for a regular tax-free income, or take it alongside your taxable pension for a tax-efficient pension income.

    In this article, we are going to look at the four main ways that you can access tax-free cash from your pension and explain how the process of actually taking your tax-free cash works. 

    For tailored pension guidance that prioritises your financial well-being, please contact the Heritage team today.

    What is a tax-free lump sum from a pension?

    You may have heard that your tax-free cash, or to give its official name, ‘Pension Commencement Lump Sum’, is an arbitrary 25% of your pension. This isn’t technically correct.

    It’s typically 25% of your uncrystallised pension fund. “What are uncrystallised funds?” you may be asking! In short, if you haven’t taken any pension benefits from your pension pot, then it is referred to as ‘uncrystallised’.

    Although the lifetime allowance was abolished in the 2023/24 tax year, there is still a maximum amount of tax-free cash that can be paid. This is 25% of the standard lifetime allowance before it was abolished, which stands at £268,275 (£1,073,100 x 25%).

    Although this has not been confirmed by the government, experts expect that this amount will be frozen. It is also possible to have more than this amount if you have any lifetime allowance protection.

    Finally, although we have said the standard tax-free cash allowance is 25%, in some rare cases, it is possible to have more than this, which is known as ‘protected tax-free cash’. You should always check this with your pension provider, as it may be lost upon transfer.

    How does taking out your tax-free cash actually work?

    Many people often think that if they don’t take all of their tax-free cash, they lose it, so they’ll just take it all and stick it in the bank (or under the mattress!).

    This is usually a terrible decision for two reasons.

    Firstly, pensions are usually exempt from inheritance tax (IHT). So by sticking your lump sum in your bank account, it will count towards your IHT threshold, which could cost as much as 40% if you exceed it!

    Secondly, as the tax-free lump sum is calculated as 25% of your uncrystallized funds, any growth in these funds can lead to a higher tax-free cash amount in absolute terms, surpassing the initial 25% of the pension value at the outset.

    An example of how your tax-free cash can ‘increase’

    Let’s use the example of a £200,000 pension. When you come to take your tax-free lump sum, it ‘crystallises’ your pension. If you haven’t taken any income or tax-free cash from your pension, then your pension is ‘uncrystallised’.

    So, if Harry takes all of the tax-free cash from his pension, he crystallises 100% of the pension fund. £50k is paid to him, and the remaining funds are crystallised within the pension pot. He can choose to take an income from these funds, but it would be subject to income tax.

    How a £200k pension pot is crystallised when taking all cash-free tax

    If you take all your tax-free cash, that makes sense. But what happens if you only take some of your tax-free lump sum? Do you lose the rest?

    Let’s use the same example, but Harry only takes £20,000 as a tax-free lump sum. He ‘crystallises’ £80,000 or 40% of his pension. £20,000 is taken as a tax-free lump sum, and £60,000 is designated to crystallised funds within his pension pot, which he can still withdraw at a later date but are subject to income tax at his marginal rate. £30,000 or 15% of his pension would still be uncrystallised, which means he could take this amount tax-free at a later date.

    Using the same example, Harry leaves the remaining pension for eight years, by which time his pension has grown to £300,000. How much tax-free cash does he have remaining? Is it still £30,000? No. It is 15% of the current value of the pension, which is still uncrystallised.

    This means he can take £45,000 as a tax-free lump, thereby crystallising £180,000. The remaining £135,000 will move to the crystallised side of his pension pot. If you remember, he can take his crystallised funds, but he will pay income tax when these funds are withdrawn.

    How a £200k pension pot is crystallised when taking a portion tax-free cash

    What are the options when taking your pension tax-free cash?

    1. Do nothing

    As we have established, the first option is to do nothing. If you choose not to take your tax-free cash, then you do not lose it. In fact, if your pension grows, then in absolute monetary terms, your tax-free lump sum can actually increase!

    2. Take a regular income drawdown made up entirely of your tax-free lump sum

    It’s possible to take your retirement income in a series of smaller tax-free lump sums. Alternatively, you can take a monthly income from a defined contribution pension pot made up entirely of your tax-free cash, meaning that no tax is due.

    Let’s consider an example where John uses his pension lump sum to create a tax-efficient income. His pension is worth £200,000 and is uncrystallised. He needs £8k from his private pension to cover his expenditure. As a Basic Rate taxpayer, he will pay income tax on withdrawals from his crystallised pension.

    John can take a monthly tax-free cash withdrawal of £666 per month (£8k a year) to meet this shortfall. He will not be able to do this indefinitely, as he will eventually use up all of his savings and his 25% tax-free lump sum. If we assume no investment growth, this will be in approximately 6 years.

    3. Take a combination of taxable and tax-free cash to create a tax-efficient income

    It is possible to take a combination of your tax-free cash and taxable income, providing a tax-efficient (or even tax-free) income. In this scenario, you can stipulate exactly how much tax-free cash and taxable income you want to take to utilise your personal allowance and maximise your tax efficiency.

    Your personal allowance is the first £12,570 of your taxable income, which is taxed at 0%. With this option, you can take taxable income from your pension up to your tax-free allowance and then take the remainder from your tax-free cash. 

    Let’s look at an example. Terrence retires at age 63. His private pension is valued at £400,000, and he has no other forms of income as he has not yet reached state pension age. His expenses come to £30,000 a year.

    For a tax-efficient income, Terrence can withdraw £12,570 from his crystallised funds (or the taxable side of his pension). As this is within his personal allowance, there is no tax due. At the same time, he can take £17,430 from his tax-free cash to make up the remaining amount that he needs. By doing this, his effective tax rate is a whopping 0%!

    You should be aware that if you take any crystallised funds or taxable income from your pension, this triggers the money purchase annual allowance (MPAA). This means the maximum amount you can contribute to your pension pot will be the lower of £10,000 or your relevant earnings.

    4. Take a UFPLS

    Another way you can take your tax-free lump sum is to take an Uncrystallised Fund Pension Lump Sum, or UFPLS for short.

    With a UFPLS, 25% of the withdrawal is tax-free. The remaining 75% comes from the crystallised pension, which you pay tax on. Breaking this down, if you take a £10,000 withdrawal as a UFPLS, then £2,500 will be tax-free, and the remaining £7,500 will be classed as taxable income.

    Seek pension advice from the specialists at Heritage Financial Planning

    If you are considering your retirement options and thinking about how to take your tax-free lump sum from your pension savings, it is wise to get professional, independent advice. Contact Heritage Financial Planning today to book a call with one of our knowledgeable and friendly financial advisers.

    Read more about how pension drawdown crystallisation works.

    The value of investments and any income from them can fall as well as rise, and you may not get back the original amount invested. HM Revenue and Customs practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen. The Financial Conduct Authority does not regulate tax planning

    Alex Norman-Jones​

    Alex Norman-Jones​

    I am one of the founders of Heritage and I am highly motivated to deliver bespoke financial planning solutions to my clients.

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