At the end of March, chancellor Jeremy Hunt confirmed the Conservative party would stick with the state pension ‘triple lock’ in its election manifesto, and Labour is likely to follow suit. This is undoubtedly good news for pensioners as the state pension will keep its real value no matter the economic conditions.
But the move draws further attention to the issue of tax efficiency in retirement, as the state pension keeps rising and takes up an ever larger portion of the tax-free personal allowance. A key way pensioners can minimise income tax is by using their pension 25 per cent tax-free lump sum. However, as this is accessible from 55 (rising to 57 in 2028), many savers have already exhausted it by the time they reach state pension age.
A common misconception here is that you must take the sum all in one go and you should take it while you can as the benefit might be scrapped. The latter is always a theoretical possibility – but it is hard to imagine a policy change of this magnitude happening without advanced warning and protection for those who were entitled but had not yet taken it.
As for the first point, it is simply not true. You can stagger your tax-free pension withdrawals by using 'uncrystallised funds pension lump sums (UFPLS)', or by splitting your pot and only crystallising a portion of it. With UFPLS, you receive a quarter of the sum you withdraw tax free, and are taxed at your marginal rate of income tax on the remaining 75 per cent. If you crystallise part of your pot, a quarter of it can be taken tax-free, and the rest will then be subject to income tax.
If you retire before the state pension age and have no other income, you can use your tax-free personal allowance and keep your tax-free cash for later in retirement.
In any case, you should think carefully before taking the tax-free lump sum if you do not need it – and many don't. A survey by Interactive Investor found that on average, 39 per cent of those who took some or all of their lump sum put part of it in a savings account. Among Interactive Investor customers (part of a separate survey by the platform), this figure fell to 24 per cent, yet some 46 per cent also reinvested part of the sum in an Isa.
While your decision depends on personal circumstances, withdrawing the lump sum just to reinvest it or leave it in a bank account is hardly ever the most tax-efficient option. If the chosen account is not an Isa, you may have to pay tax on the interest you earn. Reinvesting it in an Isa only makes sense if you are not going to exhaust your Isa allowance.
Depending on the size of your pot, leaving your uncrystalised pension to grow can result in you ultimately receiving a bigger tax-free lump sum too – albeit this is capped at £268,275. Finally, preserving your pension comes with inheritance tax (IHT) advantages, although note that if you die after the age of 75 with the lump sum untouched, your beneficiaries won’t be entitled to take this portion tax free, and all withdrawals will be taxed at their income tax rate.
