Your pension has become a great deal more versatile since pension freedoms were introduced in 2015.
If you are 55 or over, this means that you can choose how you use your pension pot. Before the changes, you could only use your pot to buy a secured income or annuity, and not much else. Today you have more choices – including pension drawdown, where you leave the money invested and call on it as you need it – and the chance to access a cash lump sum.
Pension freedoms only apply to ‘Defined Contribution’ or ‘Money Purchase’ pensions, also known as Personal Pensions and Stakeholder Pensions. This is where your contributions are used to build up your pension savings and you choose how and when you want your income. ‘Defined Benefit’ pensions are excluded.
So, when you have turned 55 (57 from April 2028) you can take the money built up in your pension savings as cash. The first 25% can be paid tax free.
So how should you use it? The answer is carefully – or the taxman will be taking more of your pension pot than you would like.
How to take your cash
A pension becomes ‘crystallised’ when you withdraw a retirement income from your pension fund or cash it in. The earliest you can crystallise your pension is currently at 55 unless you get early access due to ill health.
You can access your pension pot directly by taking a cash lump sum, known as an “uncrystallised funds pension lump sum” (UFPLS for short). You can also crystallise your pension by moving it into income drawdown or by buying an annuity.
Or you can do a combination of all three.
Traditionally many people crystalised all of their pension on a single date and took their 25% tax-free cash all in on go. The remaining 75% is then used to buy an annuity or to move into income drawdown, with income from the annuity or taken from drawdown taxed at the individual’s marginal rate.
Taking a lump sum
You can access your uncrystallised pension directly. You can take a single lump sum cashing in your whole pension, or a series of lump sums.
For every UFPLS, 25% is paid out tax-free and the balance is taxed at your marginal rate. As always where tax is involved, things rapidly become complicated. The first 25% will be tax-free but the remaining 75% will be subject to income tax. So, if you take your pension in the same tax year as you’ve received a salary, you may be pushed into a higher income tax bracket. This means you will have to pay more tax than you bargained for.
If your pension gives you the option of flexi-access drawdown. Here, the total tax-free cash you can take is usually 25% of the amount you crystallise each time. The balance goes into your drawdown account, where it will continue to be invested with the potential to grow. You can take an income from this, but you don’t need to.
When you do decide to withdraw some or all of the balance from your drawdown account, this will be taxed as income at your marginal rate. You will not be able to take any more tax-free cash from the crystallised funds.
You can gradually crystallise your pension and just take the tax-free cash by gradually moving chunks of your pension into your drawdown account, taking tax-free cash from each chunk, and keeping the balance invested in drawdown.
Doing this manually means you will need to keep a close eye on this and instruct your provider each time you wish to make a transfer.
An alternative is to use “drip-feed” drawdown. This automates the process of crystallising part of your fund by taking tax-free cash and moving funds into flexi-access drawdown on a regular basis. Many flexi-access drawdown providers offer this option.
When the tax-free cash runs out, if you need to access any more funds from your pension, you’ll need to take an income from your flexi-access drawdown fund which will be taxed at your marginal rate.
Get some expert help
The tax rules are complicated, and your money is at risk, so it makes sense to get some expert advice to make sure it is you who enjoys your 25% cash, not HMRC.
The best way to get the advice you need? Call us at Continuum.
The information contained in this article is based on the opinion of Continuum and does not constitute financial advice or a recommendation to suitable retirement strategy, you should seek independent financial advice before embarking on any course of action.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Pension income could also be affected by interest rates at the time benefits are taken.
The tax treatment of pensions in general and tax implications of pension withdrawals will be based on individual circumstances, tax legislation and regulation, which are subject to change in the future.
Accessing pension benefits early may impact on levels of retirement income and your entitlement to certain means tested benefits.
Accessing pension benefits is not suitable for everyone. You should seek advice to understand your options at retirement.
The Financial conduct authority does not regulate taxation advice.