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Should you cash in on your pension tax-free lump sum?

12 November 2024

The pros and cons of accessing your pension’s lump sum allowance.

By Matteo Anelli,

Senior reporter, Trustnet

Investors who turn 55 (57 from 2028) are able to access their pension pot but what is the best way to do that?

Many choose to take out their Pension Commencement Lump Sum (PCLA) of up to 25%, which comes tax-free. But this isn’t always the best option.

Below, Carina Chambers, technical pensions expert at digital wealth manager Moneyfarm, highlights the pros and cons to consider.

 

The pros of withdrawing cash

The 25% lump sum can help cover large expenses. Chambers said the priority for many retirees is to help family members pay for weddings or education, but other projects this lump sum can also cover include renovating homes, paying off debts and mortgages or going on holiday.

There is also a strategic benefit in taking advantage of the lump sum, as any amount beyond the tax-free lump sum will be taxed as income.

“By taking the tax-free portion upfront, you reduce the size of your pension pot and therefore the amount which will be subject to income tax in future withdrawals,” Chambers said.

 

Patience is a virtue

Withdrawing the lump sum reduces the size of your pension pot and therefore the benefits of growth from your investments, potentially leading to less income during the later years of retirement.

“Waiting a few years before accessing your 25% tax-free allowance could result in a larger amount to take tax-free in the future, plus a larger income in retirement, which may be needed for unforeseen costs or care in later life,” said Chambers.

For a practical example: on a £400,000 pension pot, the tax-free allowance would be £100,000. But by leaving the entire £400,000 invested for another five years, it could grow to £510,512, if the markets perform well and add an average return of 5% per year.

“This means your tax-free allowance would increase to £127,628, providing you with a higher tax-free lump sum,” she said.

Another risk is inflation – if the lump sum isn’t used up and left as cash, inflation will erode its value; and if it is reinvested, it would be subject to tax.

Chambers therefore suggested withdrawing only what you need, when you need it, “otherwise the best place for the cash is probably to stay invested in your pension”.

Within a pension wrapper, capital gains, dividends and interest are completely shielded from tax. “Taking the tax-free sum is an irreversible process where you move from a tax efficient vehicle to a non-tax efficient environment so making an informed decision is critical,” she warned.

Pension investments have a high statistical probability of outperforming cash but ultimately, the decision will depend upon each individual’s circumstances, needs and desires, she said. 

“Remember, you don’t have to take the full 25% in one go. That’s just the tax-free limit, not what you have to take,” she concluded.

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