‘What is the best way to use my 25pc pensions tax-free cash?’


Write to Kate with your pension problem: [email protected]. Columns are published twice a month on Tuesday mornings

Dear Kate,  

If I start taking relatively small lump sums from my as yet untouched pension, can my withdrawals be entirely tax free to begin with? 

So long as my pension provider has the right software to monitor a gradually crystallising fund, I should have some time and many withdrawals before reaching the 25pc tax-free limit (which is moving over time depending on investment performance). 

I’ve seen a professional adviser quoted saying 75pc of each pension withdrawal will be taxable as a given and it has left me a little confused.

John Rudofsky, via email 

Dear reader,

If you are aged 55 (57 from April 2028) or older you can access your defined contribution pension and take out as much or as little as you wish, whenever you like. There are different ways of accessing defined contribution pensions, and different tax rules apply depending on which one you choose.

You can access it directly by taking a cash lump sum, known as an “uncrystallised funds pension lump sum” (UFPLS for short). You can also crystallise your pension by moving it into income drawdown or by buying an annuity. 

Or you can do a combination of all three at different times. The options available may also depend on the rules of your scheme and the size of your fund.

Taking tax-free cash

Traditionally many people crystalised all of their pension on a single date and took their 25pc tax-free cash all in on go. The remaining 75pc is then used to buy an annuity or to move into income drawdown, with income from the annuity or taken from drawdown taxed at the individual’s marginal rate.  

If total income in a tax year from earned income and pensions, including the State pension, is more that the individual’s personal allowance (standard personal allowance is currently £12,570) income tax is payable on the balance.  

Nowadays there are other ways to access your pension in a more flexible way which can be more tax-efficient and better suit your income needs.  

The basic rule is that you need to crystalise a chunk of your pension to be entitled to take tax-free cash of 25pc of this amount. If you have “protected” tax-free cash, it may be higher than this.

Tax-free cash can only be paid where you also have an entitlement to a relevant pension benefit (i.e. drawdown or annuity). Your options will depend on how you access your pension.

Taking a lump sum

It’s possible to access your uncrystallised pension directly. Here, the amount is paid as a lump sum, and you can take a single lump sum cashing in your whole pension, or a series of lump sums.

For every UFPLS, 25pc is paid out tax-free and the balance is taxed at your marginal rate.  Accessing your uncrystallised SIPP in this way isn’t very flexible as it’s not possible just to take out the 25pc tax free sum in small lump sums.

Income drawdown

It looks as though your self-managed pension gives you the option of flexi-access drawdown. Here, the total tax-free cash you can take is usually 25pc of the amount you crystallise each time. The balance goes into your drawdown account, where it will continue to be invested with the potential to grow. You can take an income from this, but you don’t need to.

When you do decide to withdraw some or all of the balance from your drawdown account, this will be taxed as income at your marginal rate. You will not be able to take any more tax-free cash from the crystallised funds, regardless of whether they have grown in value.

Drip-feed drawdown  

It appears that you wish to gradually crystallise your pension and just take the tax-free cash. You can do this yourself by gradually moving chunks of your pension into your drawdown account, taking tax-free cash from each chunk and keeping the balance invested in drawdown. 

Doing this manually means you will need to keep a close eye on this and instruct your provider each time you wish to make a transfer.  

An alternative is to use an automated process called “drip-feed” drawdown. This automates the  process of crystallising part of your fund by taking tax-free cash and moving funds into flexi-access drawdown on a regular basis. Many flexi-access drawdown providers offer this option, which may be what your fund platform is offering.

When the tax-free cash runs out, if you need to access any more funds from your pension, you’ll need to take an income from your flexi-access drawdown fund which will be taxed at your marginal rate.

Alternatively, using drip feed drawdown you can withdraw the income element every time you take out a tax-free cash amount. This is more complicated than just taking out a tax-free cash amount and you will definitely need professional advice if you wish to use this option.

Money Purchase Annual Allowance

The money purchase annual allowance restricts the amount saved tax-efficiently in a pension, currently from a maximum £40,000 down to £4,000 a year. This includes your contributions, your employer’s contributions and any tax relief. 

The good news is that from April 6 the annual allowance increases to £60,000 and the money purchase annual allowance increases to £10,000 giving you more flexibility.

This allowance is triggered once you’ve started to take an income from your pension. Taking tax-free cash only doesn’t trigger the money purchase annual allowance, even if you’ve moved the balance into income drawdown.

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