- Rumours continue to circulate ahead of the chancellor’s second Budget on 26 November, meaning some savers could feel inclined to make a snap decision on whether to take tax-free cash from their pension
- Deciding how and when to take tax-free cash is an important decision and should be based on someone’s retirement income needs
- Once the decision to access your pension has been made, it cannot be reversed, and generally the money cannot be returned to the pension
- Taking money out of a pension when it is not needed could mean losing valuable tax advantages and lead to a poorer outcome
- AJ Bell has long been calling on the government to commit to a Pension Tax Lock, pledging not to make any changes to pensions tax-free cash or tax relief on pension contributions for at least the rest of this Parliament
Rachel Vahey, head of public policy at AJ Bell, comments:
“With the Budget fast approaching, the rumour mill is going into overdrive over whether there will be changes to pensions tax incentives from November.
“Those people who have built up larger pension pots must feel somewhat as if they are caught in the headlights. But they should not be making important decisions about their future retirement wealth by trying to second guess a chancellor’s Budget speech.
“Whether and when to take tax-free cash from your pension is an important long-term decision. For those who decide on balance they still wish to do so, because they need it to fund their retirement or for another reason like clearing debts, it’s important to view it as a permanent decision, and understand all the implications, including that it is not reversible.
“Leaving money in your pension until you need it is normally 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. If your pension is worth £400,000 today, your maximum tax-free cash will be £100,000. Waiting until it hits half a million – which may only take a few years with a decent rate of contribution and strong market growth – would give you an extra £25,000 tax free.
“Once the money is outside your pension, you’ll likely begin to incur some tax. For example, if the money is in a savings account, then you may have to pay tax on the interest if it exceeds your personal savings allowance. Or if the money is invested outside of your pension, you may find yourself with a capital gains and dividend tax bill, given that a pension tax-free lump sum will likely take several deposits to drip-feed into a tax shelter like an ISA.”
Pension Tax Lock
“This constant debate about changing pensions tax rules is wearing down people’s trust in the government and putting them in danger of making knee-jerk decisions which may not be the right ones for them. That is why AJ Bell is 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.
“By doing this, the chancellor could at virtually zero cost to the government put an end to rampant and damaging speculation that has in some instances has seen people make snap long-term decisions around their retirement. Not only would this provide certainty for pension savers, 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.”
When is the Budget and what could the chancellor say?
“Budget Day on 26 November is edging ever closer. But in setting the date so far in advance, Rachel Reeves has left enough time for the rumours to really take hold on what possible measures the government could adopt.
“Inevitable speculation that she will cut the maximum tax-free cash on pensions from £268,275 has once again reared its ugly head. But the chances of Reeves going through with this are low.
“Tax-free cash is the one part of the UK pensions system people both understand and value, and reducing the maximum allowed would create an outcry, including amongst public-sector workers. Importantly, though, it might not raise much money – especially in the short term – whereas this cash-strapped government needs ideas that bring in revenue quickly.
“This is a financial slow burner. In the past, when governments have cut these types of allowances, they have included protection for those who have amassed big pension pots. So, it’s likely they would need to do that again, meaning those who have built up substantial tax-free cash shouldn’t see any immediate change to their circumstances.
“Another reason why reducing tax-free cash won’t generate much revenue is because people will often spread income withdrawals over time, resulting in gradual income tax payments. While this constant drip of income tax wouldn’t raise much money in the short term, it may also lead to resentment and loss of goodwill and engagement.
“It’s important to remember that any changes would only affect those who have built up substantial pension savings, and not all pension savers.”
What is tax-free cash and when can you take it?
“Once you reach age 55 (rising to 57 from 2028), you can take up to 25% of your pension pot as tax-free cash – otherwise known as a pension commencement lump sum (PCLS). You can move the remainder into drawdown from which you can take taxable income, whenever and however much you want. Or you can use the remainder to buy an annuity – a guaranteed income for life – which will also be taxed as income. Your final option is to take the whole remaining 75% as cash, but again that will be subject to income tax. Taking such a large amount all at once could push some people into a higher tax bracket.
“There’s also another rule to be aware of. The maximum amount of tax-free lump sums anyone can take from all their pensions in their lifetime is usually £268,275. This is called the lump sum allowance (LSA). Every time someone takes a tax-free cash lump sum, they use up part of their LSA.
“So, the maximum an individual can take from their pension as a PCLS payment is the smaller of 25% of the pension pot or their remaining LSA.”
What do you need to think about before making that decision?
“Accessing your pension is an important long-term decision. If you decide to take your whole tax-free cash then you will be removing it from an environment where it can grow tax free, so people should think long and hard about what they want to do with the money.
“Some may have immediate spending needs such as house repairs. But others may not have fixed plans on how to invest the money. Money could be invested in an ISA; everyone has a £20,000 allowance, meaning a couple has £40,000. But if the remainder languishes in a bank account, it could be losing out on valuable tax-free growth at the very time when those approaching retirement need it the most.”
What happens if you change your mind?
“Once you ask a pension provider to pay your PCLS to you, then you can’t change your mind. It’s an irreversible decision. It’s therefore important you are absolutely sure you want to take your tax-free cash before making the request.
“Some people may want to pay it back into the pension through contributions, but there are a couple of pitfalls to be aware of.
“First, the amount of money people can contribute tax-efficiently to a pension is limited. Everyone can individually contribute up to 100% of their earnings into a pension and receive tax relief on this. Another check applies though – the annual allowance – which means all contributions including theirs and their employer’s, plus tax relief, must not exceed £60,000. Otherwise, the excess is subject to a tax charge.
“However, the annual allowance can be lower in some situations. Where someone is a very high earner (earning over £200,000 a year) the annual allowance can be tapered down to a minimum of £10,000. Also, if someone has taken a taxable income from their defined contribution pension – for example by taking a taxable income from drawdown – then this will trigger the money purchase annual allowance (MPAA) which will reduce the amount they, and their employer, can pay into their defined contribution pension to £10,000 a year.
“But there is another rule to be aware of. To stop people from taking their tax-free cash and then immediately ploughing it back into their pension to gain more tax relief, the government has devised a set of rules to stop ‘recycling’ PCLS payments. In broad terms, this means that where someone has taken their PCLS, their contributions cannot increase significantly above what they would normally have been, either before they take the lump sum or after. On top of this the person must not have intentionally withdrawn the money with the aim of recycling their PCLS.”
