We debunk the myths on how to take your tax-free cash

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Pensions

MoneyPlus Features Team

30th June 2017 at 2:16pm

When you’re ready to start taking money from your pension savings, there’s a lot to think about.

If you have straightforward needs, this article might not be for you. But if you have a high level of wealth and tax planning is at the heart of your retirement strategy, we help you consider how you take your tax-free cash, and bust some of the myths so that you can make the most of your pension savings.

Taking an income from your savings – flexible drawdown – as opposed to what most people used to do and take out an annuity, means you need to plan carefully to get the most from your savings and manage how much tax you pay.

We strongly recommend you talk to an adviser about this. How you’re taxed depends on your own circumstances and tax laws may change in future.

Myth 1: Take all your tax-free cash as soon as you can

Myth 2: ‘If I don’t take my tax-free lump sum, all my pension income will be taxable’

Myth 3: You can’t take tax-free cash after age 75

Myth 1: Take all your tax-free cash as soon as you can

Taking the full 25% tax-free cash allowance in one go might seem like the straightforward thing to do.

Perhaps you’ve earmarked the cash for something special – a holiday home springs to mind, or to pay off your mortgage. Or you think you should as it’s what people always did in the days when taking out an annuity was pretty much the norm.

But things have changed due to the recent pension freedoms. 

Keeping your money in your pension is usually more tax efficient

It doesn’t make sense to withdraw money from something which is tax-efficient and invest it in something which is subject to further tax, as well as removing the inheritance tax (IHT) protection a pension gives.

Most other investments you might purchase with your tax-free cash would be included in your estate and subject to 40% IHT when passed on to the next generation.

Here’s another big consideration: if you spend a quarter of your pension fund at once, will you have enough left to last you throughout retirement?

Once you take your tax-free cash, all your future pension withdrawals will be taxable. And you could end up paying more tax in the long term.

Myth 2: ‘If I don’t take my tax-free lump sum all my pension income will be taxable’

You could choose not to take your tax-free cash and use your increased fund to buy an annuity to give you a higher income in retirement.

All your annuity income would be taxable, which isn’t the case when you take money from your pension in a more flexible way: you get more choice on how you take your benefits.

And up to 25% of your savings will be tax free and the remainder can stay invested in your pension to take an income from in future.
What you take from your pension fund can be:

  • All tax-free cash
  • All taxable income; or
  • A combination of income and tax-free cash.

Which of these options might be the best fit?

You could consider only taking tax-free cash to meet your income needs, and use all of your tax-free cash entitlement in the early years of your retirement, only taking exactly what you need as an income with no tax to pay.

But your tax-free cash entitlement could soon be wiped out if you are using it all to give you an income.

Once you’ve taken all your tax-free cash, all your income is fully taxable and you could pay more tax in the long term, particularly if your income is pushed into a higher tax band in the future.

Also, some – or all – of your personal (tax free) allowance may be wasted during the years when you are just taking your tax-free cash. Which is why it can make sense to pay some tax now to reduce how much tax you’d need to pay overall throughout your retirement.

You could take a mix and match approach

The alternative is to take withdrawals which combine tax-free cash and taxable income.

You might pay a little more tax initially compared to just taking tax-free cash. But, in the longer term you may end up taking less of your pension fund each year if a quarter of it is tax free.

How? As an example, a basic-rate taxpayer needs £20,000 of spendable income. They’d need to take £25,000 from their fund if they’d already used up all of their tax-free cash and all that income was taxed at 20%.

But if they take 25% tax-free cash and 75% taxable income, they’d only need to take £23,530 each year to get the same amount of income after tax.

Which of these options is right is based on every individual’s own circumstances, of course, including how much income is needed and how long it has to last. Age, health and income needs have to be considered.

Here’s how it could work

If someone with a SIPP worth £1m needs an income of £50,000 a year (net).

They could use their tax-free cash entitlement to make withdrawals for the first five years of retirement and pay no tax. They’d then need to take £64,500 to achieve the same income, after tax, each year.

Alternatively, they could take flexi-access drawdown of £56,118 and pay some basic-rate tax every year to get the same £50,000 of spendable income. This assumes there’s no fund growth, and no change to tax rates, bands or allowances.

At this level of income, they would end up paying more tax after 9 years if they took all their income from tax-free cash first.

Some types of drawdown take this a step further and allow withdrawals which are made up of more than 25% tax-free cash, as long as it’s within their overall tax-free cash entitlement.

Myth 3: You can’t take tax-free cash after age 75

Yes you can take tax-free cash after age 75, helping you to take your income in a tax-efficient way which makes the most of your personal allowances and lower tax bands.

Consider the inheritance angle

If you were to die after age 75 before you take all your tax-free cash, how would this affect your beneficiaries?

It makes sense to take all your tax-free cash before you reach 75, providing you spend it within a short timescale while you’re still alive. But if you haven’t spent it, that money could end up in the 40% IHT net.

Pension death benefits can be paid tax free should you die before age 75. It doesn’t really matter whether tax-free cash has been taken or not because beneficiaries can take the whole fund tax-free anyway.

After 75, death benefits are taxable at beneficiaries’ marginal rate of income tax.

Take all your tax-free cash before age 75 – even if you don’t need it – and you’d need to gift it and survive seven years to keep the money out of inheritance tax.

The reality is how you plan this could lead to a possible 40% IHT charge, or beneficiaries paying an income tax charge at their own marginal rate, which may only be 20% for a basic-rate taxpayer.

Here’s how it could work

A widow approaching 75 can take £250,000 tax-free cash from her £1m SIPP.

If she were to take this cash just before reaching 75, put it in her bank account and die a year later, that £250,000 would be taxed at 40%, resulting in an inheritance tax charge of £100,000.

In this example, if she had not taken the tax-free cash her three children – all basic-rate taxpayers – may only pay 20% tax on any withdrawals, cutting that inheritance tax figure to £50,000, which is half. This does assume no fund growth, and no change to tax rates, bands or allowances.

Find out more about inheritance tax here

Bringing it all together

There’s a lot to think about and how and when to take your tax-free cash very much depends on your circumstances, now and in the future. There is no one size fits all.

We always recommend you speak with an adviser so that you can make an informed choice about what’s right for you.

 

The information in this blog or any response to comments should not be taken as financial advice. Laws and tax rules may change in the future.

A pension is an investment and you may get less back than you paid into it.

The information here is based on our understanding in June 2017.