Tax-free lump sum

When you start drawing benefits from your pension, you’re usually able to withdraw a portion of your pot tax-free. This is often referred to as a tax-free lump sum, but you may also hear it called a ‘Pension Commencement Lump Sum’ or simply ‘Tax-Free Cash’. 

How much tax-free cash can you take from your pension?

The amount of tax-free cash you can access depends on your pension scheme and the rules set by your provider. However, in most cases, you can take up to 25% of your defined contribution pension pot tax-free, providing this doesn’t exceed 25% of the Lifetime Allowance.

In some cases, you may have a hidden benefit of protected tax-free cash, which means you could be entitled to a higher amount. But don’t worry! As part of our service, we check your existing pension plans to make sure that you won’t lose out on any existing benefits by switching.

However, suppose you have a defined benefit pension, commonly known as a final salary pension. In that case, the specific scheme rules will control how much tax-free cash you’ll receive and how you can take it. You can contact your provider directly for the details of your scheme.

Taking your tax-free cash

Many people withdraw their tax-free cash from their pension pot upfront, before they access the rest of their pension savings. But you don’t always have to!

The options for your tax-free cash depend on the retirement products you choose and how much of your pension you access at a time. For example, if you transfer your pension into a drawdown plan, you could take a smaller proportion of tax-free cash now, and the rest in the future. In this scenario, there’s potential for your invested pot to grow before you take further tax-free cash, which means you could access a greater value of tax-free cash overall. However, you could also end up with less if the value goes down.

Here’s how that could look.

Imagine you’ve taken 10% of a £100,000 pension pot as tax-free cash…

The pot now contains £30,000 (or 30%) in crystallised funds, and £60,000 (or 60%) in uncrystallised funds. You invest all of this in a drawdown plan.

Two years into this fictional scenario, you need to access the rest of the tax-free cash: that’s 25% of the uncrystallised portion (£60,000 + any growth). So, how has fund performance affected things?

8% Growth

With 8% growth, the remaining tax-free cash equals £16,200.

So, you’d get an extra £1,200 tax-free cash compared to what you’d have received if you took the full 25% upfront.

-6% growth

With a 6% reduction in fund value, the remaining tax-free cash equals £14,100.

Overall, you’d lose £900 compared to what you’d have received if you took the full 25% tax-free cash upfront.

This figure shows a fictional illustration of the performance of two funds over a two-year period. It’s not intended to be indicative of any fund’s actual performance, but of the effect of performance on future tax-free cash withdrawals. My Pension Expert consider investing to be a long-term strategy, with a view to invest for a minimum of five years. The illustration doesn’t account for charges.

With drawdown, you could even choose not to take any tax-free cash as a lump sum and instead have 25% tax-free on each income payment. This method can sometimes help you to minimise income tax throughout your retirement.

However, when it comes to annuities, it’s worth highlighting that if you don’t take all of your available tax-free cash at the outset of your plan, your tax-free cash will automatically be incorporated into your annuity payments – you can’t choose to take another lump sum later down the line.

Creating a plan for your tax-free cash

Before you access your tax-free cash, you should consider how much you need to withdraw now to meet your needs, as well as what you plan to do with the rest of your pension. 

Your tax-free cash is yours to do what with as you please, but do remember that there might be benefits to leaving it in your pot if you have no immediate plans for it. These benefits may include giving your pot a chance at further tax-free growth or benefitting your beneficiaries if the worst happens, as your pension will usually remain outside of your estate for inheritance tax purposes.

Speaking to an independent financial adviser can help you to make sure that the choices you make now put you in the best position moving forward. So, give us a call today for advice tailored to you.