I’ve just turned 57 and I’m considering accessing my pension tax-free cash for the first time. What should I be thinking about?

Anonymous 

Tom Selby, AJ Bell Head of Retirement Policy, says:

The ability to access up to 25% of your retirement pot tax-free is a key benefit of pension saving and, crucially, is generally better understood and appreciated than other parts of the pension tax system.  Indeed, in many cases the primary motivation behind people accessing their pension for the first time is getting this tax-free cash. This might be because they have earmarked the money for something specific, such as paying off debts, going on holiday or buying a new car.

All-too-often, however, accessing tax-free cash as soon as possible will be driven by a fear a future government will remove the benefit. This can lead to savers making decisions that are not necessarily in their long-term interests. This is one of the reasons a central aim of pension tax policy needs to become giving savers certainty over the rules, including around tax-free cash.

In the meantime, rather than making retirement decisions based on fear of what politicians might do in the future, focus on making decisions based on your short-term needs and long-term goals and try to ignore any rumours and speculation about what may or may not happen to the tax system in the future.

THE RULES AND INVESTMENT GROWTH

Pension rules allow you to access a quarter of your defined contribution (DC) pension from age 55. This ‘normal minimum pension age’ is set to rise to 57 in 2028.

You should think carefully before taking your tax-free cash, particularly if you are considering withdrawing the money early. You will be removing the cash from an environment where it can grow tax-free, so at the very least make sure you have a plan for it. If you just take the money out of your pension and put it in a bank account earning little to no interest, its value will quickly be eaten away by inflation.

Take, for example, someone with a £200,000 pension who decides to take their maximum 25% tax-free cash of £50,000 at age 55 and puts it into a current account paying 0% interest. If they make no further pension contributions, they will receive no further tax-free cash entitlement – even if their remaining £150,000 fund is left untouched and benefits from investment growth.

If we assume that remaining fund grows by 4% per year after charges, by age 65 it could be worth around £222,000, alongside the £50,000 tax-free cash they withdrew at age 55 (i.e., £272,000 in total).

If, however, they had left their entire £200,000 fund untouched and enjoyed the same 4% investment growth post-charges, by age 65 they could have a total fund worth around £296,000, with £74,000 available tax-free. That is almost 50% more tax-free cash than if they had accessed their pot at age 55.

UNDERSTANDING MPAA AND PARTIAL CRYSTALLISATION

If you have specific things you need to spend money on and your retirement pot is your only option, just accessing your tax-free cash – or a portion of your tax-free cash – can be a sensible option.

Where you also flexibly access taxable income from your pension pot, the ‘money purchase annual allowance’ (MPAA) will be triggered, reducing your annual allowance for making new contributions from £60,000 to £10,000. You will also lose the ability to carry forward up to three years of unused annual allowances from the three previous tax years.

If, however, you just withdraw tax-free cash from your pension, you will not trigger the MPAA and so can retain the full £60,000 annual allowance.

If you do need to take tax-free cash from your pension, you could consider partially ‘crystallising’ some of your pot in drawdown. Crystallising in this context just means choosing a retirement income route. This could allow you to generate the tax-free cash you need, while leaving the ‘uncrystallised’ part of your pension – including the attached tax-free cash entitlement – untouched and with the ability to continue growing.

It is also worth remembering that by withdrawing money out of your pension, you are moving it from an environment where it will usually be free from inheritance tax (IHT) to one where it will form part of your estate.

That is not to say, of course, that people should not access their tax-free cash, but simply to emphasise the importance of considering what you plan to do with the money when you access it. And whatever you do, do not let it fall victim to the ravages of inflation.

WHAT ABOUT DEFINED BENEFIT PENSIONS?

Members of defined benefit (DB) schemes, which promise a guaranteed income from a certain age, usually based on your salary and years of service, also offer a tax-free lump sum, although sometimes this will be offered in exchange for a lower promised pension at retirement. The terms of this DB tax-free lump sum offer will vary from scheme-to-scheme.

When considering whether to take this lump sum, it is again important to think about what you will do with the money and the potential impact inflation could have. In addition, where the lump sum is taken in exchange for a reduction in your annual pension, you should make sure this lower pension will still deliver the retirement lifestyle you are hoping for.

DO YOU HAVE A QUESTION ON RETIREMENT ISSUES?

Send an email to asktom@sharesmagazine.co.uk with the words ‘Retirement question’ in the subject line. We’ll do our best to respond in a future edition of Shares.

Please note, we only provide information and we do not provide financial advice. If you’re unsure please consult a suitably qualified financial adviser. We cannot comment on individual investment portfolios.

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