- Someone who decides to take their full 25% pension tax-free lump sum at age 55 may forgo just over £63,000 in potential growth by age 65 compared to leaving the amount invested, according to analysis by AJ Bell*
- If that same person moved their lump sum into a Cash ISA or invested it via a Stocks and Shares ISA, they could still be out of pocket to a tune of £45,000 and £18,000 respectively
- Rumours continue to circulate ahead of the chancellor’s second Budget on 26 November, meaning some savers could make a snap decision on whether to take tax-free cash from their pension
- Taking your tax-free cash is an irreversible decision that should be made with your long-term retirement goals in mind
- AJ Bell recently launched a petition calling for the government to commit to a ‘Pension Tax Lock’, pledging not to make any changes to pension tax-free cash or tax relief on pension contributions for at least the rest of this Parliament to provide certainty for savers
New analysis by AJ Bell shows that taking your pension tax-free cash earlier than planned could result in losing a significant amount of money, compared with leaving it invested to be taken at a later date.
Someone with a pension pot valued at £500,000 at age 55, who takes their full 25% tax-free cash from their pension and moves it into a cash savings account paying 4%, could lose out on £63,169 in tax-free cash by age 65, compared with leaving the amount invested in their pension. That same person drip-feeding their lump sum into a Cash ISA or investing it via a Stocks and Shares ISA would be able to mitigate the impact by using an ISA’s tax shelter status, but could still be worse off by £45,029 and £18,358 respectively*.
As is common before any Budget, rumours surrounding the fate of pension tax incentives, including pension tax-free cash, have emerged as possible levers the chancellor could pull to boost public finances. But it’s important to remember that these are just rumours and there are multiple reasons why the chancellor may think twice before opting to go down this route, not least the potential uproar from public sector pension savers.
Pension savers should ensure any decision to take their tax-free cash is aligned with their long-term strategy for retirement, rather than a knee-jerk reaction to speculation.
Difference in lump sum available by age 65:
Source: AJ Bell. *Assumes 6% investment growth in the pension and Stocks and Shares ISA after charges and that the individual is a higher rate taxpayer who continues working full-time until age 65, but no longer contributes to their pension. Cash account and Cash ISA assume an interest rate of 4%. Both Cash and Stocks and Shares ISA scenarios involve drip-feeding lump sum into the ISAs in £20,000 chunks each year (in line with the annual ISA allowance of £20,000) until all the cash is invested in the ISA.
Tom Selby, director of public policy at AJ Bell, comments:
“Although the many-headed hydra of pre-Budget rumours can take a variety of forms, perhaps the most widely accepted in the pensions industry to influence behaviour and potentially cause untold damage to the retirement prospects of hard-working Brits is speculation around pension tax-free cash. The same rumours emerge every year almost in lockstep with the weeks leading up to the Budget, whether the incumbent government of the time decides to hold one or more major fiscal events.
“This has a direct impact on pension savers who have saved diligently throughout their careers under the proviso that they could access a tax-free lump sum of up to 25% of their pot, often wreaking havoc with their longer-term retirement plans. But the potential for a medium-term hit worth tens of thousands of pounds highlights that the decision to access your tax-free lump sum is not one that should be taken lightly under any circumstances, whether there are rumours swirling or otherwise.
“Analysis by AJ Bell shows that someone with a pension pot worth £500,000 who takes their full 25% tax-free lump sum at age 55 could be worse off than if they’d left it invested to a tune of just over £63,000 by the time they turn 65. This chasm in the wealth prospects of those who continue to nurture their pension fund versus those who decide to access their pension at an earlier stage is partly explained by the assumption that they stick their entire tax-free lump sum into a cash account paying less interest over time than leaving it invested.
“But even someone drip-feeding their lump sum into a Cash ISA or investing it via a Stocks and Shares ISA could still be worse off by around £45,000 and £18,000 respectively, despite benefitting from the ISA’s tax-free status. On top of this, assuming no change to existing rules, anyone who takes their full 25% allowance out of their pension will likely end up subjecting at least a portion of it to tax and may also push themselves into a higher tax bracket to boot, resulting in a higher tax bill.
“For example, if the money is in a cash savings account, then you may have to pay tax on the interest (along with the interest on other taxable cash savings accounts) if it exceeds your personal savings allowance – up to £1,000 tax free for basic rate taxpayers and £500 for higher rate taxpayers. A recent FOI obtained from HMRC by AJ Bell showed that pensioners make up almost half (44%) of all taxpayers hit by tax on their savings interest. Anyone considering taking their tax-free cash early could see themselves fall into that group and leave their money exposed to savings tax, as well as any other taxes.
“If the money is invested in the stock market outside of your pension, you may also find yourself lumped with a capital gains or dividend tax bill, even if you intend to move it into a tax shelter such as an ISA. This is because a pension tax-free lump sum could easily take a number of deposits over several years to drip-feed into the account within the ISA’s annual allowance of £20,000, and therefore leave at least a portion of it exposed to tax while that process is ongoing.
“This is why it is crucial to have a clear plan for your money when accessing your pension, either by taking a lump sum or a regular income. While you may wish to put that money towards a paying off the last of a mortgage or other debts, leaving money in your pension until you need it is often the best course of action. It can continue to grow tax free, meaning you should be able to take a bigger tax-free cash lump sum in a few years’ time.”
Pension Tax Lock campaign
“This constant debate about changing pension tax rules is wearing down people’s trust in the government and putting them in danger of making knee-jerk decisions which may not prove to be the right ones. That is why AJ Bell recently launched a Parliamentary petition calling on the government to commit to a Pension Tax Lock, vowing not to change the rules on pension tax relief or tax-free cash for at least the remainder of this Parliament, with support for the petition surging to over 20,000 signatures within weeks to elicit a government response.
“In its initial response, the government refused to commit to the Pension Tax Lock, thereby effectively subjecting anyone spooked by pre-Budget rumours on the fate of tax-free cash to a potential headache worth thousands of pounds. But there is still an opportunity for Rachel Reeves to grasp the nettle at the Budget and announce a tax lock, not least since the Petitions Committee called on the Treasury to provide a ‘revised response’ to the petition. Not only would this provide certainty for pension savers at virtually zero cost to the Treasury, but it would also neatly compliment the government’s stated aim to boost pension adequacy and encourage investing in the UK stock market over the long term.”
