Tax-free cash is great! Taking it the right way is even better!

Everything you need to know about using tax free cash from your pension pots

Everyone loves tax-free cash. So the great news is you can currently take 25% of any pension pots tax free when you retire. Here’s the low-down on the best ways to take advantage of this……

With tax-free cash from your pension, you win twice over: you paid no tax when you saved into the pension, and then you get to take a quarter of it back out tax free as well!

As ever, to make the most of this, there are several things to think about.

I want to take my pension savings a bit at a time – what are my options?

If you are using drawdown to access your pension savings flexibly, there are three ways to take money out and manage your tax. 

We’ve listed them below, from the simplest, to the best option for keeping your tax to a minimum. 

The choices you have may depend on your pension provider. Not all providers offer all three of these options.

Option 1: A tax-free lump sum when you start taking your pension

Let’s say you have a pot of £200,000 at retirement. You can take 25% of it (so, £50,000) tax free as a lump sum. You can move it out of your pension and do whatever you want with it. It’s as simple as that, and all pension providers will let you do it.

This sounds great, but if you don’t plan to spend the money straight away, to pay off a mortgage or debts for example, you need to find a home for it. 

You can just put it in the bank. But then you would get little growth as interest rates are so low. And, you may be taxed on any interest.

Or, you could put up to £20,000 each year tax-free into an ISA (2021/22 rates) to get better tax free growth.

But be aware: taking money from a pension and putting it into a bank account or ISA will mean that it counts towards your inheritance tax limit should you die. All the time that it stays in a pension pot, it does not.

So, if you feel that inheritance tax might be an issue for you, think carefully before committing to this option.  Even if you invest the money tax-free in an ISA, you and your heirs might stand to lose more than you gain.

Option 2: Get 25% of each payment tax free

Most, but not all, providers will allow you to take 25% of every pension withdrawal tax-free. So, each time you take money out of your savings pot, you can do so tax-free.

The big advantage of this is that more of your money stays in the pension. Your investments will continue to grow and so you’ll have a larger pot of money for the future. All investment returns in a pension are tax-free and if you die the money isn’t counted towards the inheritance tax limit.

That’s all good…but as we are talking specifically about tax-efficiency, there are some disadvantages too. Let’s look at an example.

Everyone has a tax-free income limit, called your personal allowance. In 2021/22, that’s £12,570. That income could be from work, or pensions – or other sources of money such as letting a property.

So, if your pension is the only source of income you have, you can take £12,570 of income out of your pension tax-free. To make the numbers easier, we’ve rounded this down to £12,500.

But, let’s say you want to take £20,000 out in a single year.  The ideal way of doing this would be to be able to break this down into £12,500 of taxable pension income, and £7,500 tax-free. That way, you’d pay no tax at all.

However, if you take £20,000 out from your pension, £5,000 (25%) would be tax-free.  The other £15,000 would be taxable. Of that £15,000, you wouldn’t have to pay tax on £12,500. But that still leaves £2,500 which will get taxed. 

Option 3: Take tax-free income as and when you need it

The final option, which some pension providers offer, involves taking, or “crystallising”, parts of your pension as you go along.

If it’s available to you, this can mean you pay the least tax and keep as much of your money in your pension as possible, until you really need it. But, it’s a bit complicated. Are you ready?

Let’s say (again) that you want to have an income of £20,000 per year and you have a total pension pot of £200,000.

The most tax-efficient way of doing this is to take £12,500 income that won’t be taxed (your personal allowance), and work out a way not to pay tax on the remaining £7,500.

To create a 25% tax-free pot of £7,500,  you can ‘crystallise’ £30,000 of your pension (4 x £7,500).  Your provider can then pay you £7,500 tax-free within a year of crystallising those funds.

The provider can also then pay you £12,500 of taxable income – but you won’t have to pay any tax on it (because that’s your personal allowance). 

So, you’ll get the whole £20,000 tax-free.

The rest of your pension (£170,000) remains uncrystallised, so you can crystallise further lumps in the future and receive 25% tax-free, until the whole pension is crystallised.

To make that work, you’ll need to keep careful track of what you’ve crystallised so far, think about what you will need tax-free for the next year and keep a running total.

Yes, it’s complicated.  But if you are able to do this through your provider and you’re willing to keep tabs on how much of your pot is crystallised, you’ll reap the benefits in terms of paying less tax.

What if I want to use all of my pension to buy a guaranteed income, rather than taking withdrawals from my pot?

If you buy a guaranteed income, called an annuity, rather than using drawdown, Option 1 above (the 25% lump sum) is the only way to go.

Any income from the annuity is taxable so if you don’t take all the tax-free cash up front before buying the annuity, you’ll lose that tax break.

Help is coming to make this all much simpler

It’s pretty complicated having to work out how to pay the least amount of income tax on your retirement income on your own. Don’t forget you’ve also got to add the State Pension and any other taxable income into the mix.

Whatever option you choose, it’s pretty complicated to work out for yourself how much to take from your pension and savings pots to give you the total income you want after tax each year. 

No worries, Guiide will work all this out for you. Even better, we are now working to build a pension product to link to your Guiide plan so you can get it paid as a base tax efficient plan automatically. More details are here. This means:

  • Your Guiide plan will be paid automatically whichever income pattern you choose, until you say otherwise. You no longer have to think about how much to take from month to month, it just gets paid.
  • We make sure you pay the least amount of tax, without lots of complex tax planning on your part.
  • We help you track your remaining pension pots and long term plan, so you don’t run out of money.
  • You can get ad hoc withdrawals tax efficiently, on top of you plan, if you need more money in any month.

We only develop things our users want. So if the idea of an automated retirement plan sounds good, then please provide your email address and we’ll keep you informed as we develop this.