Should you take a 25% tax-free pension lump sum in instalments?

Taking out a 25% tax-free lump sum sounds appealing but it might not be the best way to manage your pension

For many savers, being able to take 25% of their pension savings as tax-free cash when they reach retirement is one of the main attractions of private pensions. But 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. And in today’s financial climate, it may make sense to opt for instalments instead. 

For one thing, money left in your pension fund can continue to be invested; given the current volatility of investment markets, leaving savings to benefit from a future recovery could prove astute. 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 fall into 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 tax is a potential problem for your family, that may be very valuable.

How to organise your pension

There are a couple of different ways to organise your pension income in this fashion, and taking independent financial advice on the best option will make sense for most savers. The simplest route is to leave your pension “uncrystallised”, in the jargon. 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.

There are pros and cons to both these arrangements, and the right answer 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. 

While you're here, it's also worth reading up on what the recently announced changes to the pensions charge cap mean for you, as explained by my colleague Saloni Sardana. 

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