In our weekly series, readers can email in with any question about retirement and pension saving to be answered by our expert, Tom Selby, director of public policy at investment platform AJ Bell. There is nothing he doesn’t know about pensions. If you have a question for him, email us at [email protected].
Question: It seems highly likely that the Chancellor is going to reduce the level of tax-free lump sum that can be taken from a defined contribution (DC) pension to £100,000. This would be a substantial loss of tax-free income in my case. I no longer add to my pension pot and, so far, have no need to access it currently as I’m living off income from my ISAs. If this new legislation goes through, will it probably only impact only those who have not accessed their pension or will it cap those that have already accessed their pension but not reached £100,000? In other words, if I drawdown £1, will that be enough to keep me under the current legislation, albeit I will lose and additional tax-free growth? Could I send an email instructing my adviser to start the drawdown immediately after the Chancellor’s speech only if a £100,000 limit is announced, assuming the chancellor was going to put the motion into place immediately rather than next April? I know it’s all a bit “crystal ball.”
Answer: That’s more than a bit “crystal ball”! Beyond a few speculative stories, there has been no concrete indication that the Government will make any changes to tax-free cash – although clearly it is a possibility before every Budget. This uncertainty is destabilising for people, which is why AJ Bell is urging the Chancellor to commit to a pensions tax lock, pledging not to change tax relief or tax-free cash at least for the rest of this Parliament, to provide certainty for savers.
Before getting into some of the things you should consider when taking your tax-free cash entitlement, a quick reminder of how it works.
“Defined contribution” (DC) pensions are the most common types of retirement plan in the UK. Contributions to these schemes benefit from upfront tax relief at your marginal rate and tax-free investment growth. You can access these pensions from age 55 (rising to age 57 in 2028), with up to a quarter available tax-free and the rest taxed as income. The maximum amount of tax-free cash most people can take over their lifetime is capped at £268,275.
To access your tax-free cash, you need to choose a retirement income route for the rest of your pot. The most popular options are drawdown (where you keep your fund invested and take an income to suit your needs) or buying an annuity (an insurance product paying a guaranteed income for life). Note that if you opt for drawdown, you don’t have to take any income out – you just have to select this option.
If Rachel Reeves were to reduce pensions tax-free cash entitlements, it is impossible to say for certain how it would be done. Having a blanket cut-off would feel particularly harsh on anyone who had built up a tax-free cash entitlement above that level, so the chancellor could choose to introduce a “protection” scheme to ensure people aren’t impacted retrospectively. This is what previous governments have done when the lifetime allowance (which was abolished in April) was reduced. This would, however, reduce the revenue any such move would raise for the Exchequer.
You could email your adviser asking them to instruct your provider to choose drawdown at the point in the speech this is confirmed, although it is unlikely any change would be effective immediately.
Why you should think carefully before taking your tax-free cash
If you have specific things you need to spend money on and your retirement pot is your only option, just accessing your tax-free cash – or a portion of your tax-free cash – can be a sensible option.
Where you also flexibly access taxable income from your pension pot, the “money purchase annual allowance” (MPAA) will be triggered, reducing your annual allowance for making new contributions from £60,000 to £10,000. You will also lose the ability to carry forward up to three years of unused annual allowances from the three previous tax years. If, however, you just withdraw tax-free cash from your pension, you will not trigger the MPAA and so can retain the full £60,000 annual allowance.
If you do need to take tax-free cash from your pension, you could consider partially “crystallising” some of your pot in drawdown. Crystallising in this context just means choosing a retirement income route. This could allow you to generate the tax-free cash you need, while leaving the “uncrystallised” part of your pension – including the attached tax-free cash entitlement – untouched and with the ability to continue growing.
It is also worth remembering that by withdrawing money out of your pension, you are moving it from an environment where it will usually be free from inheritance tax (IHT) – and could be passed onto your beneficiaries completely tax-free – to one where it will form part of your estate for IHT purposes.
If you put the money in a bank account, you may also pay tax on your interest, as well as risking seeing its value eroded over time by inflation. If you choose to invest the money, make sure you use a tax-efficient savings vehicle, such as an ISA, so you aren’t vulnerable to capital gains tax (CGT).
That is not to say, of course, that people should not access their tax-free cash, but simply to emphasise the importance of considering what you plan to do with the money when you access it.
