Taking a cash lump sum from your pension may seem like the perfect solution to many of life’s problems. These five questions will help you decide whether it is the right thing to do.
Taking a cash lump sum from your pension may seem like the perfect solution to many of life’s problems. You could pay off that last bit of mortgage, start or invest in your own business, help a child buy a property, or splash out on a brand new car. So, not surprisingly, since pension freedoms were introduced in 2015 people have jumped at the chance to extract as much cash as they want from their pension – exactly what the freedom rules were designed to allow.
However, when it comes to pensions and tax, you are essentially playing a game of chess with the taxman, because the way in which you take the cash and what you do with it can have unwelcome consequences.
Question 1: How much cash can I take tax free?
The rules state that up to 25 per cent of a pension, such as a self-invested personal pension (Sipp) or defined-contribution workplace plan, can be withdrawn as tax-free cash from the age of 55 (or earlier if you have serious health issues). Larger taxable sums up to the value of 100 per cent of the pot can also be withdrawn. But the rules do not apply to defined-benefit (DB) schemes, which typically offer members a choice of a lump sum with reduced pension payment or a higher pension payment.
So if you have a personal pension pot worth £100,000, you could withdraw up to £25,000 in cash without having to pay tax on it. To do this you would need to move your pot into drawdown, taking £25,000 in cash and investing the rest as you choose, or converting it into an annuity that would pay you an income for life. In this situation, you are crystallising your pension and the lump sum paid to you is known as a Pension Commencement Lump Sum (PCLS). All income received from either the annuity or the drawdown plan is taxable – just like a salary.
Question 2: Should I consider taking my whole pension in one go?
There are a couple of other options when it comes to extracting cash. You can, for example, convert a portion of your pot and take 25 per cent of this as cash. At some point in the future you can return to your remaining pot and take another tax-free lump sum or turn it into an annuity or a flexible drawdown plan.
You can also take your whole pot as cash either through a series of lump sums or all in one go. If you do this, you’ll get 25 per cent of it tax-free and 75 per cent will be taxable.
Taking cash out in chunks from time to time or extracting the whole lot in one go are options that appeal to many people because it means they don't have to make decisions about investments in drawdown or accept paltry returns from an annuity. They can simply draw cash as they need it. If someone is not planning to retire for another 10 years, but wishes to reduce their working hours, they might like the idea of taking cash lump sums every six to 12 months. The rest of their pension pot, meanwhile, can continue growing and accumulating contributions.
But the more cash you take from your pension, the more you risk the ability to generate a sustainable stream of income for as long as you need it. Ideally, you should have other pensions to lean on for income so that you don't run out of money. Around half of all people retiring currently take whole pension pots as cash, but nine in 10 of these have another source of pension income, for example a DB scheme.
You might have to move your pot to a new provider if your current one does not offer the option you want, and you should always check what charges are applied to withdrawals.
If you choose to take your pension as cash without converting it to an annuity or drawdown, this is described as an uncrystallised funds pension lump sum (UFPLS).
Question 3: Are there any strings attached to the options?
Firstly, how you take cash and how much you take can result in the amount of tax-free contributions you are able to pay into your pension pot dropping from £40,000 a year to £4,000. This reduced allowance is known as the Money Purchase Annual Allowance (MPAA). Tax relief gives an important boost to pension pots and many people who dip into their pension intend to carry on saving into their Sipp or employer’s scheme. Anyone who continues paying in as they did before taking a cash lump sum risks a shock bill at the end of the tax year if they and their employers pay in too much, as HM Revenue & Customs will demand that the excess tax relief is repaid.
There are three events that will trigger the MPAA – all of which can be described as flexibly accessing your pension.
1. Withdrawing cash from an uncrystallised pot, or taking your whole pension as cash and closing it. An exception is when you take cash from a 'small pot' of up to £10,000. You can withdraw all of a small pot in one go. If you take this option you will not trigger the MPAA.
2. Taking more than 25 per cent cash from a crystallised pot when you move money into an annuity or drawdown.
3. Taking up to 25 per cent as a cash lump sum and then taking an income from money you convert into drawdown. Even if you only move a portion of your pension into drawdown, as soon as you take an income from this you trigger the MPAA. But if you move some of your pot into drawdown but do not yet take an income from it, or you buy an annuity, the MPAA is not triggered.
You don’t need to worry about the MPAA if you don’t intend to make any further contributions, or if an allowance of £4,000, which works out at a total contribution of just over £330 a month, is sufficient. Kay Ingram, director of public policy and chartered financial planner at LEBC Group, points out that if you take cash withdrawals from a personal pension, but your workplace contributions are made into a defined-benefit scheme, your “reduced” allowance when MPAA is triggered is still £36,000.
Question 4: Could I incur higher tax bills?
If you take too much cash in one go it will be added to all your other income, and you could move into a higher-rate tax band losing far more in tax than you expect. There is also a high risk that you might be forced to pay emergency tax when you take a taxable cash one-off sum, or even when you receive your first income payment in drawdown. This is because the money will be taxed on the basis that you will be receiving this amount every month. You can claim the excess tax paid back through self assessment or by completing a claim form available on HMRC’s website.
Worryingly, says Kay Ingram, many people who have not previously completed a self-assessment tax form will assume that “HMRC has got their tax right and never question it”.
Because of the risk of unintended consequences and the fact that UFPLS withdrawals are not reversible, it’s always a good idea to work through all the options available to you before proceeding with a cash withdrawal. Below are some of the ways in which you can help to ensure that you receive the maximum tax-free payout from your pension pot.
Question 5: Should I take extra for a rainy day?
Don’t take out more money than you need. Andrew Tully, technical director at Canada Life, sets out the following example of an investor with a £1m pension pot.
“If that person takes 25 per cent as a tax-free cash lump sum they will receive £250,000, but might only need £25,000.” Not only will they need to find a home for the £250,000, which might be left to languish in a bank account, they will also increase the size of their estate for inheritance tax purposes.
Instead, only keep as much cash as you need and invest a greater proportion in drawdown or an annuity. Or crystallise only a percentage of your pot to get the tax-free cash you require while leaving as much as possible within it. That money could continue to grow until your next withdrawal. The crystallised pot, less the cash you take, can be fully invested in drawdown with no income paid out. Martin Reynard, senior pensions manager at Blick Rothenberg, says: “For example, if you have a pot of £200,000 and you want a sum of £20,000 you would crystallise £80,000 of your pension pot, taking £20,000 as cash, leaving £60,000 in your crystallised fund and £120,000 in your pension pot.”
Mr Tully adds: “For people with larger pots who are gradually easing into retirement, phasing withdrawals makes sense. [Doing this] will allow individuals to create lump sums and supplementary income from the crystallised side of their pension that suit their needs."
If you end up with too much cash you won’t be able to recycle it back into your pension, collecting another round of tax relief on the way in. HMRC has strict matching rules in place to thwart this, adds Mr Reynard. If you do not need pension income from the portion you convert into drawdown and want to avoid triggering the MPAA, you don’t need to set up payments from the drawdown portion – it can remain fully invested with no income drawn from this until a later date.
The MPAA also won’t be triggered if the converted pot is used to buy a standard annuity, one paying a level or inflation-linked income.
|Lump sum options and consequences|
|Option||Tax||Will MPAA be triggered?|
|Take up to 25 per cent as a cash lump sum, converting the remaining amount into an annuity or drawdown||There will be no tax to pay on the cash lump sum. Income received from an annuity or drawdown pension will be taxable.||No if you buy a fixed annuity. No if you remain fully invested in drawdown and do not take an income. Yes if you go into drawdown and take an income.|
|Take 25 per cent of a portion of your pension pot as a cash lump sum, converting the rest of the portion into an annuity or drawdown, leaving the balance untouched.||There will be no tax to pay on the cash lump sum. Income received from an annuity or drawdown pension will be taxable.||No if you buy a fixed annuity. No if you go into drawdown but do not take an income. Yes if you go into drawdown and take an income.|
|Take more than 25 per cent as a cash lump sum, converting the remainder into an annuity or drawdown||Only 25 per cent of the lump sum will be tax free. The rest will be taxed as income. Income received from an annuity or drawdown pension will be taxable.||Yes. Your future pension contributions will be limited to £4000 a year even if you buy an annuity with what's left or don't take an income from drawdown|
|Take 100 per cent of a pension pot with a value of more than £10,000 as a cash lump sum in one go||Only 25 per cent of the lump sum will be tax free. The rest will be taxed as income.||Yes|
|Take 100 per cent of a pension pot with a value of less than £10,000 as a cash lump sum in one go||Only 25 per cent of the lump sum will be tax free. The rest will be taxed as income.||No|
|Take all of the pot as cash in a series of lump sum withdrawals||25 per cent of each withdrawal will be paid out tax free and 75 per cent will be taxable||Yes|