In our weekly series, readers can email any question about pension and pension saving is to be answered by our expert Tom Selby, director of public policy at investment platform AJ Bell. There’s nothing he doesn’t know about pensions. If you have a question for it, email us at money@inews.co.uk.
Question: I am 66 years old and have just started receiving the state pension. I also have a private pension to take and I am in two minds what to do with it. Should I start taking it now or should I hold off and let it grow? I think I can afford to do that because I don’t have a mortgage. Will the lump sum I’m allowed to take go up if I wait?
Response: There are lots of benefits to using a pension to save for retirement, one of which is the ability to take up to a quarter of your full pot tax-free from age 55. For most people, the maximum amount of tax-free cash they can take is capped at £268,275 over their lifetime.
However, just because you can do something doesn’t necessarily mean you should – and there are plenty of good reasons to forgo taking your pension in tax-free cash if you can afford it.
This is especially important now, with near-constant rumors and speculation about what fiscal nightmares Chancellor Rachel Reeves might have in her budget, scheduled to take place the day before Halloween. While these stories can be unsettling, it’s usually better to focus on your long-term retirement strategy rather than reacting to rumours.
How does it work?
Pension rules allow you to access up to a quarter of your ‘defined contribution’ (DC) pension completely tax-free from the age of 55. This ‘minimum normal pension age’ will rise to 57 in 2028. To access your cash tax-free, you need to choose a retirement income path for the rest of your fund. For most people, this will be either going into drawdown (where you keep your fund invested and get a steady income) or buying an annuity (an insurance product that pays you an agreed level of income for the rest of your life).
However, taking your money tax-free is not a decision that should be taken lightly. You’ll be removing cash from an environment where it can grow tax-free, so if you choose to access it, at 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 that earns little or no interest, its value will likely be eaten away quickly by inflation.
If left in retirement, your tax-free cash entitlement may have the opportunity to grow tax-free as well. The impact of this could be substantial. Take, for example, someone with a £200,000 pension who decides to take the maximum 25 per cent of their £50,000 at age 55 and puts it into a current account paying 0 per cent interest . If they stop making pension contributions, they will no longer receive any tax-free cash entitlement – ​​even though the remaining £150,000 fund is left untouched and benefits from investment growth.
Assuming the remaining fund grows by 4% a year after tax, by age 65 it could be worth around £222,000, alongside the £50,000 cash they withdrew at age 55 (ie £272,000 in total).
If, however, he had left his entire £200,000 fund untouched and enjoyed the same investment growth of 4% after tax, by age 65 he could have a total fund worth around £296,000 of pounds, with £74,000 available tax-free. That’s nearly 50% more money tax-free than if he’d accessed his pot at age 55.
Understanding the ‘Money Purchase Annual Allowance’
If you have certain things you need to spend money on and your retirement pot is your only option, just accessing the tax-free cash – or part of the tax-free cash – may be a sensible option.
If you flexibly access taxable income from your pension pot, the ‘money purchase annual allowance’ (MPAA) will be triggered, reducing the 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 previous three tax years. If, however, you only withdraw tax-free cash from your pension, you won’t trigger the MPAA and so can keep the full £60,000 annual allowance.
If you need to take tax-free cash out of your pension, you might consider partially ‘crystallizing’ part of your drawdown pot. Crystallization in this context just means choosing a retirement income route. This can allow you to generate the tax-free cash you need, while leaving the ‘uncrystallised’ part of your pension – including the tax-free cash entitlement attached – untouched and with the ability to continue to grow.
It’s also worth remembering that by withdrawing money from your pension, you’re moving it out of an environment where it will usually be exempt from inheritance tax (IHT) – and could be passed on to your beneficiaries completely tax-free – in one where it will form part of your estate for IHT purposes.
That’s not to say, of course, that people shouldn’t access their cash tax-free, but simply to highlight the importance of considering what you intend to do with your money when you access it. And whatever you do, don’t let it fall victim to the ravages of inflation.
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