To withdraw or not to withdraw, that is the question.
For many retirees, whether to withdraw the tax-free lump sum from their pension pot is one of the biggest financial questions they will tussle with. It’s an option that allows you to take out up to 25% of your pension pot as tax-exempt cash. And after decades of saving, having access to a significant sum of money entirely tax-free may seem enticing – but there’s a lot more that pension planners need to consider.
So, before making any important financial decisions about your lump sum, it’s vital to ensure you fully understand the options available to you and to weigh them up carefully.
How does the tax-free lump sum work?
When you reach the minimum pension age (55 at the earliest, set to increase to 57 in 2028), you can typically withdraw up to 25% of your pension pot tax-free, up to a maximum of £268,275.
This lump sum can be taken all at once or in stages, depending on the flexibility of your pension scheme. The remaining 75% of your pension pot is typically subject to income tax, whether you choose to withdraw it as a lump sum, take it as income, or purchase an annuity.
In practical terms, if your entire pension was worth £100,000, you could take up to £25,000 as a tax-free lump sum. You would then be subject to income tax on the pension payments you receive each year from the remaining pot of £75,000.
Weighing up the pros and cons
Naturally, one of the biggest appeals of withdrawing a lump sum is the immediate financial flexibility it affords, providing you with immediate access to a significant amount of money. This can be useful for a variety of things, such as paying off outstanding debts, paying for home improvements, making big-ticket purchases, or simply having accessible funds for emergencies or unexpected expenses.
Another perk is that taking the tax-free lump sum early can help savers manage their tax burden more effectively during retirement. This is because a smaller pension pot should result in less taxable income when you begin drawing from the rest of your pension.
On the other hand, there are drawbacks to consider, too.
Withdrawing a lump sum will reduce the size of your pension pot, which may result in a lower income during retirement year-on-year. If your pension is your primary – or only – source of retirement income, this can be especially concerning.
Money left in a pension pot also continues to grow tax-free, potentially increasing your retirement income over time. So, by withdrawing a lump sum, savers lose out on this compound growth, which could further result in less income during retirement.
What’s more, having access to a large sum of money could lead to the temptation to spend it quickly on non-essential items. Without careful planning, you could deplete your savings faster than anticipated, leaving you with less financial security in the long term.
Seek advice before making a decision.
Deciding whether to withdraw a tax-free lump sum from your pension is a complex decision that can have significant implications for your financial future.
Every individual’s situation is unique, with factors like your retirement goals, access to alternative income sources, and overall market conditions all coming into play.
It’s also important to factor timing into your decision. Certain schemes may require you to take out tax-free cash by the age of 75 – so even if you’re not sure when exactly to take it out, it’s important to be aware of the terms and conditions of your pension scheme to avoid any nasty surprises.
In any case, it’s vital to consult with an independent financial adviser (IFA) before making any decisions.
An IFA, like those in the MPE team, can provide tailored advice based on your individual financial and retirement goals. From there, they can help you assess the impact of withdrawing a lump sum on your overall retirement strategy, as well as explore alternatives that might better suit your needs.
Ultimately, seeking professional support and advice can help pension planners make well-informed decisions that align with their long-term financial goals, allowing you to enjoy the comfortable, financially secure retirement you deserve.