What to do after you take tax-free cash from a pension

In the lead up to recent Budgets, many retirees opted to take tax-free lump sums from their pension after rumours that there would be cuts to the allowance.

But tax-free lump sums have not been changed yet, leaving some in an awkward position of now having a chunk of cash sitting in their accounts, with no need to spend it right away. Even for those for whom this doesn't apply, working out what to do with cash removed from a retirement pot requires some careful thought.

Money that's been taken out of a pension can’t just be put back in. This action is called ‘recycling’ and there are regulations in place to prevent this. These rules mean that for those who have taken their lump sum, they cannot reinvest an amount that is far above what they would have typically invested in the past. In addition, the pensioner cannot withdraw funds with the intention of reinvesting.

Once your money is out of your pension, it’s a bit like trying put toothpaste back in the tube. So, what can you do instead to keep your money working for you?

Using your ISA allowance

If you haven’t already used up your ISA allowance, putting funds that would otherwise be sitting in a bank account into an ISA is a simple way to protect yourself from unnecessary tax on interest, investment gains or dividends. When you go to reinvest this money through an ISA, it’s likely a good time to have a think about what you’re investing in. There’s a good chance you will need access to that money in the next five or so years, so you may want to allocate your assets in a way that supports that.

You may choose investments that pay dividends, which you can then use to help fund retirement. If these are in an ISA, you won’t be liable for tax on them. You could alternatively opt to put the money in a Cash ISA, where you would enjoy the same protection from HMRC. 

Remember, the new tax year begins on 6 April, so to make the most of your allowance you could subscribe £20,000 before that date and another £20,000 after to invest as much as possible without exposure to capital gains or income tax. Though if putting funds into a Cash ISA, it is important to note that the allowance reduces to £12,000 from April 2027 for those under 65.

Investing or saving through other methods

There is, of course, always an option to reinvest the cash through a Dealing account. However, if you choose this method, your investments will be subject to capital gains and income tax on dividends. This may deter some from investing, but keep in mind that if your cash is in a savings account that accumulates interest, you could be taxed on that as well.

If you're looking to get the best return on your cash then using the Cash savings hub, which would sit alongside any investment accounts you hold with AJ Bell and allow you to access some of the most competitive savings rates available, is another option.

Currently, basic rate taxpayers pay 20% on savings income, with an allowance of £1,000. For higher rate taxpayers, the allowance decreases to £500 and the rate increases to 40%. Additional rate taxpayers have no allowance and pay 45%. All these rates are set to increase by 2% starting in April 2027.

If you choose to invest, dividend rates feature slightly lower taxes and everyone has an allowance of £500 before the tax kicks in. Any amount above this is subject to tax, at a rate of 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers, and 39.35% for additional rate taxpayers. Starting in April 2026, the rate of tax will increase to 10.75% for basic rate taxpayers and 35.75% for higher rate taxpayers but will stay the same for additional rate.

Some investments will offer tax breaks, but it’s important to ensure that these suit your needs beyond the tax relief. Gilts are subject to income tax, but any capital gains are not taxed, which may attract some investors. There are also options such as Venture Capital Trusts (VCTs) and enterprise investment schemes for tax breaks. VCTs offer relief of up to 30% on income tax (dropping to 20% from April 2026) and no capital gains tax. But these are high risk investments, and they must be held for a certain time period to reap the tax rewards. So, if you are planning to use the funds in the next few years or are heavily reliant on the money being held in these investments, it is likely not to be suitable.

Whatever choice you make with your lump sum, remember to consider the future as well as your current situation and tax considerations. Most of us don’t want to pay any more than we must to HMRC. But aiming to be tax efficient should not take priority over investing in a way that makes sense for your lifestyle and future.

Opting to spend

If you’ve taken out your tax-free lump sum, you might also consider simply spending it. This may seem obvious, because it is what you saved money in your pension to do. But, if there is something you planned to do later in retirement, like purchase a new property or take a big trip, it could make sense to use it sooner rather than later. The spending power of your money will decrease overtime due to inflation, so if the alternative is just leaving the cash in your savings account, you might be better off making a purchase now.

If you choose to do this, you will of course want to ensure that you have plenty of money left to carry you through the rest of retirement. But reaping the rewards from the money you worked so hard for throughout your career, is a good option for those that can afford to do so.

You could also use these funds to pay off a remaining mortgage if you have one. But remember, you can only overpay a certain amount (often around 20%) without incurring a penalty. So, check the terms of your mortgage before proceeding. Another avenue having the money outside of your pension opens up is gifting.

With pensions on track to be subject to inheritance tax from April 2027, it could make more sense to pass on assets before that point. As long as gifts occur seven years before death, there is no inheritance tax on them. But if you choose to do this, it’s essential to hold on to enough assets that you can comfortably enjoy your retirement. Also, remember that if these gifts do occur within seven years of death, the assets could be subject to inheritance tax of up to 40%.