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How do i take my tax-free cash from my pension?

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01 August 2017, at 12:00am

DYLAN JENKINS looks at the most efficient and sensible ways to withdraw ‘TFC’

AS AN INDEPENDENT FINANCIAL ADVISER I am frequently asked about the best way to take the Tax-Free Cash (TFC) entitlement from a pension, and in short, there isn’t one “best way”. But I am not alone in our concern over the number of common misconceptions that have grown around this topic, leading to decisions that are often far from the most suitable for an individual. One very widely held view is that you should always take the full amount of TFC (usually 25% of the fund value) as soon as you are able when you retire. Of course, this may still be attractive to some people, for example if they have planned to use this for a particular purpose, such as a specific purchase or to pay off their mortgage. Some individuals, however, may simply take the cash in one go, because that was their expectation when they started saving or they prefer to see it in their bank account than in their pension. If money is required for a specific purpose, it could be used from the pension or, if available, from other non-pension assets, so let us look at the difference in tax treatment. Using non-pension savings for the purchase would be Inheritance Tax (IHT)-neutral as you are using savings subject to IHT to buy another asset subject to IHT. But as money retained in the pension fund is usually IHT-free, if the purchase is made from pension funds, this is converting an IHT-free asset into one which may now be subject to IHT. And worse, if the tax-free cash is taken but not spent or  gifted! It makes no sense to withdraw money from a tax-efficient arrangement to invest in an asset which is itself subject to more tax, while at the same time removing the IHT protection the pension wrapper provides when most other investments will be included in the estate for IHT. Furthermore, before anyone withdraws a quarter of their pension fund, they need to be sure that what they have left in the fund will support them throughout their retirement. The tax-free lump sum could be an important component in providing their income. And bear in mind that once all of the TFC has been taken, all future withdrawals are fully taxable, so in the long-term that could mean much more tax. Another misconception is that it is best to take all of the TFC before you take any income from the pension fund. It is entirely possible to draw only TFC to meet income needs in the early years until the TFC has been exhausted, which can be attractive, but it’s also important to consider not just what gives the least amount of tax to pay today, but a more efficient strategy for all of the years of retirement – now and in the future. Some or all of the personal allowance may not be used, so will be wasted during the years when just TFC is taken. So, it could make sense to extract some taxable income, up to the personal allowance at the very minimum. Otherwise, once all the TFC has  been taken, all future income is taxable and this could mean future income is pushed into a higher tax band. Therefore, it may make sense to pay some tax now, to reduce the overall tax paid throughout retirement. Another change in more recent years is the ability to draw your tax-free cash after age 75, which wasn’t permitted in years gone by, but it can still be taken now in later life as part of a taxefficient income withdrawal strategy designed to maximise your personal allowances and lower tax bands. The main downside here is that if you die after age 75 before all of the TFC has been taken, it is no longer taxfree when taken by your beneficiaries, so an opportunity has been wasted. So, it can make sense for all TFC to be taken before reaching 75 providing it’s going to be spent within a fairly short timescale. But if you don’t spend it, the tax-free amount today may be charged at 40% IHT tomorrow. As a result, if you take the TFC before age 75 and you don’t need it for your own purposes, then to escape IHT you could gift it and hope to survive seven years. This can be risky if you later need the money to sustain your own lifestyle, so obviously needs careful consideration. Another thought is that it may be better to take TFC at the earliest opportunity to avoid Lifetime Allowance Tax (LTA) charges. This strategy can help those close to the LTA avoid the tax charge. This is because the remaining pension fund will be smaller, as will any investment growth retested at 75. It’s important, though, to consider the impact of all tax charges, not just the LTA charge in isolation. What really matters is how much you have available after all taxes have been deducted and how much you can pass to future generations. Taking TFC may reduce the impact of the LTA charge, but it must be remembered that funds will be moved out of the pension wrapper and no longer protected from IHT and tax on investment income and gains. So, for some, it may make better financial sense to allow funds to grow in the pension and pay some LTA charge than try to avoid it completely. In summary, how and when to take a lump sum will very much depend on your individual circumstances and needs (both current and future). There is no “one size fits all” solution and what’s best for two people will  differ. It’s therefore essential that all the consequences of taking TFC, and when, are considered and professional independent advice should definitely be sought on this matter. 

  • Note that if you have any protected tax-free cash greater than 25% of the fund, you must take all of the cash in one go to secure the higher amount.