When considering retirement and drawing money from your pension pot, one of the key things to understand is how much you can take tax free as a lump sum. This can be an important part of your retirement planning, as any tax free cash represents money you can access immediately without paying any tax.
In this article, we’ll look at the rules around tax free pension withdrawals, how much you can take as a lump sum, and the implications for your overall pension savings. We’ll also consider how best to use any tax free cash you take.
How much tax free cash can I take from my pension?
The maximum tax free amount you can withdraw from your pension is 25% of the total value of your pension pot. This 25% is known as your Pension Commencement Lump Sum (PCLS) or tax free lump sum.
So for example, if you have a total pension pot worth £100,000, the maximum you could take as a tax free lump sum would be £25,000. This £25,000 could be taken immediately as cash, without incurring any tax liability.
This 25% rule applies across all of your pension savings combined. So if you have multiple different pension pots, you can take 25% tax free from each pot, but in total across all pots the tax free amount is capped at 25% of the total value.
Some key points about the 25% tax free pension rule:
– It applies at the point you start drawing retirement benefits from a pension pot, this is known as ‘crystallisation’.
– It’s available from age 55 (rising to 57 in 2028).
– It’s optional – you don’t have to take it if you don’t want to.
– If you don’t take it at the outset, you lose the option to take it tax free later on.
– Some pension types like final salary/defined benefit schemes may calculate the lump sum differently.
– The remaining 75% of your pension pot will be taxed as income when you withdraw it.
So in summary, 25% of your total pension savings can be taken as a tax free lump sum when you reach age 55. This can provide useful tax free cash in retirement.
Should I take the maximum tax free cash from my pension?
Just because you can take 25% of your pension tax free, doesn’t necessarily mean you should. There are a few factors to consider:
– **It reduces your remaining pension pot** – Taking a chunk as tax free cash leaves less money invested inside your pension. This reduces future potential investment growth.
– **It may push you into a higher tax band** – Large cash withdrawals could increase your income for that tax year, meaning more tax paid on pension withdrawals.
– **Impact on pension income** – A smaller pension pot means lower income in retirement. Carefully consider how much income you need.
– **Effect on pension flexibility** – Depleting small pots too much could reduce future flexibility.
– **Lifetime allowance** – Taking large lump sums can affect your lifetime allowance. Only take what you need.
– **Benefits means testing** – Larger cash sums may impact your entitlement to means tested benefits.
– **Estate planning** – Pension assets can be passed on after death, unlike cash lump sums.
As a general guide, only take the tax free cash you actually need, rather than automatically taking the maximum. Think carefully about the long term impact on your retirement income.
When should I take the tax free lump sum?
You can choose when to take your tax free cash from age 55 onwards (57 from 2028). This doesn’t have to be at the same time you start drawing pension income.
Some options to consider:
– Take it early on at age 55 to have maximum flexibility with the cash lump sum.
– Take it later on if you don’t initially need the cash, allowing your pension to grow further.
– Take it over time in chunks as and when needed rather than all at once.
– Use it to supplement income during low income years, and draw pension income in higher income years.
– Hold off until you need it for a major expense like gifting to family or paying off debts.
Review your cash flow needs in retirement and take tax free cash strategically when it suits you best. Don’t feel you have to take it immediately at age 55.
How is tax free cash calculated on defined benefit pensions?
Defined benefit (DB) pensions, also known as final salary or career average schemes, calculate tax free cash differently to defined contribution pensions.
The DB scheme rules will specify how the lump sum is worked out. It is commonly calculated as:
– **1/60th of final pensionable salary for each year of pensionable service** – For final salary schemes.
– **3/80ths of revalued pensionable salary for each year of service** – For career average schemes.
For example, if you had:
– Final salary of £60,000
– 40 years of pensionable service
– Retire at age 65
Your tax free cash from a final salary scheme would be:
40/60 x £60,000 = £40,000
Whereas for a career average scheme with the same service it might be:
3/80 x £60,000 x 40 years = £45,000
So DB schemes can often give a tax free lump sum of more than 25%. Always check your specific scheme rules.
Tax free cash from multiple pensions
If you have more than one pension, you can take tax free cash from each pot. But in total across all pensions combined, the tax free amount is capped at 25% of the total value.
For example:
| Pension 1 value | £200,000 |
| Pension 2 value | £300,000 |
| Total pension value | £500,000 |
Here you could take:
– 25% of £200,000 = £50,000 from Pension 1
– 25% of £300,000 = £75,000 from Pension 2
Giving total tax free cash of £50,000 + £75,000 = £125,000
This is within the 25% limit of the total £500,000 pension value.
Taking tax free cash from multiple smaller pots can help maximise use of the 25% allowance if values differ. But always check the total across all pensions stays under 25% of the combined values.
Tax free cash from partially crystallised pensions
If you start accessing one of your pensions but leave other pensions untouched, special rules apply around the 25% tax free cash limit.
Each time you crystallise a pension and take benefits, you get 25% tax free cash entitlement based on the amount crystallised.
For example:
| Total pension | £500,000 |
| Crystallise £100,000 | Take 25% tax free cash = £25,000 |
| Remaining pension | £400,000 |
Later you crystallise the remaining £400,000 and can take another 25% as tax free cash:
0.25 x £400,000 = £100,000
So over two crystallisation events, total tax free cash = £25,000 + £100,000 = £125,000.
This is still within 25% of the overall pension value, in line with the rules.
This phased approach can allow you to access tax free cash in stages over time as needed.
Tax free lump sum from pension drawdown
If you move your pension into drawdown, you can take tax free cash and drawdown flexibly together.
For example with a £200,000 pension:
– Move £100,000 into drawdown
– Take 25% of £100,000 as tax free cash = £25,000
– Leave remaining £75,000 in drawdown to draw income
– Leave remaining £100,000 uncrystallised in your pension
This allows you to get tax free cash from part of your fund, while leaving the rest to potentially grow. A phased approach like this can offer more flexibility.
The 25% tax free amount depends on how much you designate for drawdown, not the total pension value. So you could have multiple smaller drawdowns each with 25% tax free cash.
Tax free lump sum and the lifetime allowance
While 25% tax free cash is not limited by the lifetime allowance, taking it can impact your lifetime allowance in some cases.
The lifetime allowance is the total pension amount you can build up over a lifetime before extra tax charges apply. This is currently £1,073,100.
When you crystallise a pension and start taking benefits, this is tested against the lifetime allowance. Tax free cash is not counted, but the remaining pot crystallised is.
If this exceeds your available lifetime allowance, there may be a tax charge on the excess known as the lifetime allowance charge.
So taking large tax free lump sums can sometimes impact your lifetime allowance. It’s important to consider this if you are close to the lifetime allowance.
You may be able to apply for lifetime allowance protection if you have large pension benefits built up. This can help reduce potential charges if taking tax free cash and drawdown together.
Death benefits and tax free cash
If you die before taking your tax free cash, it can still be paid as a lump sum death benefit. This depends on your pension scheme rules.
Tax free cash doesn’t need to die with you – make sure your pensions include death benefit nomination forms, so the lump sum can be paid tax free to any beneficiaries on your death.
For defined contribution pensions where death occurs before age 75, beneficiaries can usually take the entire pot as a tax free lump sum if they wish.
If death is after 75, beneficiaries pay tax at their marginal rate when they take lump sum or income payments from inherited pensions.
Tax free lump sums from pension scams
Beware of pension scams that offer to release tax free lump sums from your pension before age 55. This is illegal under UK law.
Common techniques include:
– Offering loans against your pension – illegal before age 55.
– Transfers to overseas pensions that release cash – usually a scam.
– Investments in unregulated products like overseas property developments.
– Reviews of your pension promising instant access to tax free cash.
All legitimate tax free cash from pensions can only be taken once you reach age 55. Be very wary of any offers to access it earlier, which are normally scams. Avoid free pension review services, and take regulated financial advice if considering transferring a pension.
Conclusion
Tax free cash from pensions can be useful, but needs to be planned for carefully as part of your overall retirement strategy.
– Up to 25% of your total pension savings can be taken tax free from age 55.
– This doesn’t have to be taken all at once – phased drawdown can allow tax free cash to be taken in stages.
– Consider the impact on remaining pension investments and lifetime allowance before taking large lump sums.
– Tax free cash can also be paid to beneficiaries if you die before taking it yourself.
– Beware of pension scams advertising early access to tax free pension cash.
Taking time to understand the rules around tax free pension lump sums can help maximise the benefits. Seek regulated financial advice if considering your pension options.