While there are many potential uses for this money – from paying off a mortgage to spending it on travel – you don’t have to take it all at once. When times are more turbulent, it may make sense to opt for instalments instead.
For one thing, money left in your pension fund can continue to be invested; if the investment markets are volatile, then leaving some of those savings invested could mean they benefit from any future recovery, and mean you are better off overall.
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Equally, by taking your tax-free cash in instalments, rather than upfront, you can use it to supplement your pension income. This may be useful for younger savers waiting for state pension benefits to become available, for example, or simply for anyone anxious about making ends meet.
Another benefit of staggering your tax-free cash is that once you take money out of your pension, it will be considered as part of your estate for inheritance tax (IHT) purposes.
Savings inside a pension plan, by contrast, can generally be passed on to your heirs with no IHT liability to worry about. If the inheritance tax bill is a potential problem for your family, that may be very valuable.
Taking a pension lump sum in instalments: how to organise your pension
If you plan to take your tax-free pension lump sum in instalments, there are a few different ways to organise your pension income. It’s worth highlighting that taking independent financial advice on the best option will make sense for most savers.
The simplest route is to leave your pension ‘uncrystallised’. This simply means you’ll take money directly out of your savings, rather than structuring withdrawals through an income-drawdown plan or an annuity purchase.
Each time you make a withdrawal, 25% of it will be covered by your entitlement to take 25% of the fund tax-free, so there will only be income tax to pay on the other 75%.
The alternative is to use a more conventional drawdown arrangement – known technically as ‘flexi-access drawdown’ – but stagger the transfer of your savings into the scheme. Each time you need some money from your savings, you take a tax-free lump sum directly from your remaining pension fund.
Then, for each £1 taken, you must move £3 into the drawdown plan. You’ll only pay tax on this cash when you withdraw it from that fund. You can keep doing this until you’ve exhausted the funds in your original pension plan.
Is it worth taking my tax-free pension lump sum in instalments?
There are pros and cons to each of these methods for taking your tax-free pension lump sum in instalments. The right option for you will depend on your individual circumstances.
But either way, there’s a good chance you’ll ultimately get access to more tax-free cash than you would have been entitled to by taking the full 25% entitlement upfront. If your pension fund continues to appreciate, so will the cash value of the tax-free portion of it.
Be realistic, however: turning down your upfront tax-free cash may well be a luxury you can’t afford. If the full 25% lump sum is part of your financial-planning arrangements as you move into retirement, you’ll need to take it, or change your plans. However, if you can afford to do without the full lump sum in one go, instalments have real advantages.
It's also worth reading up on what the changes to the pensions charge cap mean for you.
David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.
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