During competitions, gymnasts are scored on the complexity and execution of their technique. The execution score starts at 10, with points deducted for any mistakes, including a poor landing. This means that, no matter how well they perform the technique, a gymnast could miss out on victory if they don’t correctly execute the landing.
Retirement planning is much the same. No matter how successful you are at building wealth during your working life, you might run into problems if you don’t correctly execute the landing and draw sustainably from your savings when you transition into retirement. It’s particularly important to consider tax efficiency when accessing your pension because some of your pension income could be unnecessarily taxable.
You can normally take the first 25% of your pension tax-free
You can usually access your pensions from the “normal minimum pension age” (NMPA) of 55 (rising to 57 from 2028). The first 25% of your pension can be taken tax-free as a Pension Commencement Lump Sum (PCLS), up to the Lump Sum Allowance (LSA) – this stands at £268,275 in 2024/25. Any income that exceeds the LSA may be subject to tax.
Additionally, income that you draw from the remaining 75% of your pension will normally be taxed at your marginal rate of Income Tax, if it exceeds your Personal Allowance (£12,570 in 2024/25). It’s strongly advisable that you put some thought into how you use the tax-free portion of your pension. Here are two options that you may want to consider.
Option 1: Taking a Lump Sum Withdrawal
You could take the fully allowable allowance as a tax-free lump sum. Once you reach the NMPA and can access your pensions, you may decide that you want to take the full 25% tax-free lump sum in one go, subject to the maximum of £268,275. If you have multiple defined contribution (DC) pension pots, you can take the first 25% of each without paying Income Tax, on the proviso that you do not exceed the LSA. However, if the total amount you draw from all pensions exceeds the LSA, you will normally pay some tax.
In some cases, you might decide that you need the full 25% as soon as you reach 55, whether you’re retired or not. You could use the money to achieve certain goals such as paying off the remainder of your mortgage, for example. Alternatively, you might wait until later in life before accessing your pensions for the first time and take the full tax-free lump sum then. However, many pension schemes allow you to take your tax-free cash in smaller instalments, and this may benefit you in certain circumstances.
How It Works
Most pension schemes allow you to withdraw up to 25% of your pension pot as a tax-free lump sum. This one-off payment lets you enjoy a sizeable cash boost without incurring any immediate tax liabilities.
The Benefits of Taking a Lump Sum Withdrawal
- Immediate access to a large sum of money.
- Flexibility to use the cash for major expenses, investing, or paying off debt.
Points to Consider When Taking a Lump Sum Withdrawal
- Assess whether a lump sum fits with your long-term retirement strategy.
- A large cash withdrawal could reduce the size of your pension pot, affecting your future income.
- Ensure you have a clear plan for managing or reinvesting the cash to keep your retirement funds growing.
Option 2. Using Flexible Pension Cash Withdrawals
You may benefit from taking your tax-free lump sum in instalments. In some cases, taking your tax-free lump sum in smaller amounts could help you generate a tax-efficient income from your pension. This is because you can often draw from the tax-free and taxable portions of your pension at the same time.
For instance, you might take £1,000 from the 25% tax-free lump sum and £1,000 from the remaining 75% each month. This would give you a total annual income of £24,000 from your pension.
However, only £12,000 comes from the taxable portion of your pension, meaning you don’t exceed your Personal Allowance and won’t pay Income Tax, provided you don’t draw any more income from elsewhere (including a State Pension). You might also combine the income you draw from your pensions with funds from other sources, so you can be as tax-efficient as possible.
For example, if your general living expenses are £30,000 a year, you might draw £24,000 from your pension in the way described above. You could then take the remaining £6,000 from any excess cash you hold or alternatively an existing investment – i.e. an Individual Savings Account (ISA). You don’t pay Income Tax, Dividend Tax or Capital Gains Tax (CGT) on returns or growth from an ISA, and you won’t pay tax when withdrawing the funds either. As such, you could potentially use a combination of your tax-free lump sum and funds from an ISA to generate an income of £30,000 without paying tax. This assumes you don’t draw any additional income, such as from your State Pension, for instance.
If you are drawing your State Pension or generating income from other sources as well as your personal pension, you might exceed the Personal Allowance and pay tax. In this instance, being strategic with your tax-free lump sum could still help you reduce the amount you pay.
Additionally, when you draw smaller amounts from your pension, you leave the rest of the funds invested in a tax-free environment, meaning you could potentially see more growth in the future. Bear in mind that you can only benefit from this tax-efficient income until you have fully utilised your tax-free lump sum, so this strategy is typically more suited to early retirement. Once you have used your 25% lump sum, you may need to explore other ways to mitigate the tax you pay. We can support you with this.
How It Works
Under flexible drawdown arrangements, you can withdraw amounts from your pension pot as and when needed. You can choose to take a series of smaller payments or tailor withdrawals to match your monthly or annual expenses.
Benefits of Using Flexible Pension Cash Withdrawals
- Better control over your cash flow and financial planning.
- Ability to take only what you need, leaving more funds invested and growing over time.
- Potentially lower tax impact, as you can spread withdrawals over several tax years.
Points to Consider Using Flexible Pension Cash Withdrawals
- Plan carefully to ensure withdrawals align with your spending requirements and income needs.
- Monitor market conditions and your investment performance to adjust your withdrawal rate accordingly.
- This approach works well if you’re looking for an ongoing income supplement rather than a one-off boost.
How to Decide Which Option is Right for You
Consider your own unique goals when deciding how to take your tax-free lump sum. When deciding how to take tax-free cash from your pension, you will want to consider your own unique goals. For example, you may want to fund a dream holiday or two in retirement and taking some of your tax-free lump sum could help you achieve this.
Conversely, if you don’t have a specific use for the lump sum, taking it all right away may not be the most suitable option. Instead, you might benefit from leaving it invested and drawing smaller amounts over time to generate a tax-efficient income. In other words, your 25% tax free lump sum benefits from tax free growth whilst its still in your pension. Taking this out without a purpose and leaving in the bank will reduce your tax efficiency and limit the returns you receive. Ask yourself these questions:
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Do I need a large amount of cash upfront, or do I prefer a steady income stream?
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How might each option affect my long-term pension pot and future retirement income?
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Have I factored in any potential changes in tax legislation that may impact withdrawals over time?
It may also be useful to speak with a financial adviser who can help tailor a strategy that suits your retirement vision while ensuring tax efficiency.
Expert Tips and Considerations
Review your pension scheme details to understand exactly how your particular pension scheme works regarding tax-free cash options. Not every plan is the same, so check your scheme’s guidelines.
Plan ahead and consider your long-term retirement goals before making a decision. A lump sum might be ideal for immediate needs, while flexible withdrawals can provide ongoing support.
Stay informed about tax rules and pension benefits that can change. Keeping abreast of these developments ensures that you can adjust your strategy accordingly and avoid surprises later on.
Get in touch with a Financial Adviser
We can discuss your retirement goals and determine the most suitable ways to take tax-free cash from your pension. Email hello@fcadvice.co.uk or call 0333 241 9900 to find out more.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate tax planning. A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.