The tax-free pension lump sum is a key feature of retirement planning for millions of people who are budgeting for their future. If you are aged 55 or over, you are entitled to take up to 25pc of your private pension as a tax-free lump sum up to a maximum of £268,275.
However, reports that the Chancellor is considering plans to slash the lump-sum limit to £100,000 – 37pc of the current amount – has been making savers question what to do next.
Rumours of pension changes in Labour’s upcoming Budget have caused some savers to scramble to take their tax-free lump sum while they can, fearing that they could lose the bulk of this allowance at the end of the month.
Interactive Investor, an online investment platform, saw a 58pc increase in the volume of cash withdrawals from self-invested personal pension (Sipp) accounts that make up the 25pc tax-free lump sum allowance in September, compared to the same period in 2023.
But the decision to pull money out of your pension early can come with costly ramifications, and must be carefully planned and considered, financial advisers have warned.
Here, Telegraph Money explains the adviser-approved way to approach taking your pension lump sum early, and the risks you need to weigh up.
In some instances, it can make financial sense to take a tax-free lump sum from your pension – but savers should ensure they are doing so for the right reasons, as what you “save” in a possible future tax charge could be vastly outweighed by the loss of future pension growth.
Jason Hollands, managing director of wealth and accountancy firm Evelyn Partners, said: “If you were planning to take your tax-free cash shortly anyway and have a clear, intended use for it, such as clearing a mortgage or buying a holiday home, then taking it a little earlier than planned out of abundance of caution is one thing.
“But pulling out a quarter of your retirement fund in a panic, only to then leave it languishing in a cash savings account or investments that will be subject to tax – possibly increased tax in respect of capital gains and dividends – rather than leaving it to grow tax-efficiently within a pension could prove a big mistake that you will come to regret.”
Helen Morrissey, head of retirement analysis at investment firm Hargreaves Lansdown, agreed: “Placing your pension lump sum in a bank account risks poor growth and its purchasing power being eroded over time by inflation. Even if you were to take the money, regret your decision and try to reinvest it back into your Sipp, you risk falling foul of recycling rules that could see you clobbered with a tax charge – the potential for poor outcomes is huge.”
If you are taking a lump sum early, you don’t need to do it all at once – instead, it may be better to take it in chunks as and when the money is needed, explained Ms Morrissey: “This means you don’t take too much and then have a surplus that you don’t know what to do with – you should always have a plan for your tax-free cash.
“Other options for what you can do with your tax-free cash include making the most of the other tax allowances available to you. One way is to use up your own Isa allowance of £20,000 per year, but you can also use it to bolster your family’s future by using it to top up your children’s Junior Isa (£9,000 per year) or Junior Sipp (£2,880 per year topped up to £3,600 by tax relief). You can also use it to top up the pension of your partner and improve your joint finances.”
Keeping your money in a pension means it benefits from a number of tax perks that you’ll lose by withdrawing a lump sum early.
Ms Morrissey said: “Grabbing a lump sum now risks derailing people’s retirement planning as people act in haste and repent at leisure.
“Taking the money out of a pension removes it from a tax-efficient environment where it has the time to grow over time. Depending on what you do with it, you are potentially exposing your hard-earned cash to a range of taxes that it wouldn’t have been in a pension, such as inheritance, capital gains and dividend tax.”
Firstly, you pay no capital gains tax or dividend tax on any money generated by investments within your pension. If you take money out of your pension and invest it, any gains you make or dividends you receive over the annual tax-free allowances will be subject to tax – unless the money is held in a stocks and shares Isa.
Given the Isa allowance restricts you to paying in up to £20,000 in each tax year, only small lump sum withdrawals will be able to benefit from this tax-free wrapper.
In addition, pension savings are not considered to be part of your estate, so you can pass on your pension to your loved ones free of inheritance tax, which could mean a huge tax saving for your heirs. However, bringing pensions into the scope of inheritance tax is another measure Labour is reported to be considering, and more information may be announced at the Budget.
Labour’s specific plans are not yet clear, and will be confirmed at the Budget. Even if the tax-free lump sum is reduced, it does not mean that any policy changes would come into effect on that day. Some changes will require consultations, and the industry may need time to implement the changes.
Instead, advisers said the Government would be very likely to give people time to carefully consider their next steps.
“If changes were made, they would be unlikely to happen overnight,” said Ms Morrissey. “The likelihood is that transitional arrangements would need to be put in place for people who have accumulated more tax-free cash entitlement – so people have time to see if these changes will come to pass before making a decision.”
Lily Megson, of financial advice firm My Pension Expert, said: “People need to understand that nothing has been confirmed, and any changes announced in the Budget are unlikely to take effect until the next financial year at the earliest, giving them ample time to plan accordingly.”
Mr Hollands agreed: “The Chancellor might back off a raid on tax-free cash altogether, or go ahead but ensure transitional arrangements are put in place that would protect your ability to use the current tax-free cash limit of up to £268,275.”
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