What’s the best way to use your pension tax-free lump sum? Would it be to pay off the mortgage? What about the benefits of taking it in tranches to supplement income and should it be taken as an uncrystallised lump sum each time? Or from a drawdown plan?

Harriet

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

There is no ‘best way’ to use your tax-free lump sum, but it’s important to think carefully about what you want to do with the money, rather than simply taking it out of your retirement pot at the first opportunity. In fact, there are potential benefits to leaving your tax-free cash within your pension for as long as possible.

Firstly, any growth your fund enjoys within a pension will be completely tax-free. Second, if your fund does grow, the amount you can take as tax-free cash will grow as well, until you reach the maximum which for most people is £268,275 – although investment returns are never guaranteed and can be volatile.

Your pension fund needs to support you throughout retirement, so taking out a quarter and spending it frivolously could be problematic later on.

If you are determined to access your tax-free cash, you need to have a plan before going down this road. That will vary based on personal circumstances and preferences, but a good starting point is considering the basic principles of financial planning.

Your first port of call should usually be paying off any high-cost debts and then building a rainy-day fund in case of emergency.

If you’ve got both of those sorted, you can start to consider things like paying off your mortgage early, if that’s a priority and you are able to, or looking at more luxury spending, like renovating your home or travelling. But make sure doing this in the early stages of retirement won’t jeopardise your lifestyle later on.

You don’t have to take all your tax-free cash at once – it is possible to access your pot in tranches, either through drawdown or by taking ad-hoc lump sums and using your tax-free cash as part of your annual income. This will enable you to stretch your pension pot further and will also give the tax-free cash entitlement you don’t touch the opportunity to grow over the long-term.

Another important thing to consider is inheritance tax, also known as IHT. Pensions can usually be passed on completely free of IHT and are usually tax-free if you die before age 75. If you die after age 75, your pension will be taxed in the same way as income when your beneficiary (or beneficiaries) come to make a withdrawal.

If you take money out of a pension and haven’t spent it before you die, it will count towards your estate for IHT purposes.

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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