The recent Pension Freedoms that were introduced in April 2015 has meant that planning your retirement income has never been more important. Deciding how and when to take your Tax-Free Cash from your pensions is one of the most significant decisions you will make. As it is tax-free, it can be very compelling to think that you should take it all as soon as you can. However, this could not be further from the truth.
Let’s begin with the basics… what is Tax-Free Cash?
During your working life, you will typically accrue a number of pensions, having worked for numerous employers and picking up a Personal Pension or two along the way.
When you’re ready to draw on your pensions, you may be able to take some of your benefits as a Tax-Free Cash lump sum, known as the Pension Commencement Lump Sum (PCLS). If you have a Defined Contribution (Money Purchase) pension, you will normally have the option to take up to 25% of the pension value as Tax-Free Cash.
The word ‘commencement’ may lead you to think that you must take it all at the outset. However, this is not always the case and just because you can, doesn’t mean you should.
How does Tax-Free Cash work?
Let’s assume you have accumulated £400,000 in your personal pension during your working life and, as at today, this is completely untouched. This accumulated pension is referred to as your ‘Uncrystallised’ part, because you have not taken any benefits from this yet.
25% of this Uncrystallised pension could be taken as Tax-Free Cash and the remaining 75% could also be taken, but would be taxable. Once you’ve taken your Tax-Free Cash from the Uncrystallised part, the remaining 75% becomes ‘Crystallised’, because there is no longer the option to take any Tax-Free Cash, as follows.
Now, you may be wondering why all this requires so much terminology for something that’s relatively simple in principle. If you were to take all your Tax-Free Cash on Day 1, it would be simple, because the entire pot becomes fully Crystallised overnight.
However, let’s say you only want to withdraw £10,000 of your Tax-Free Cash from your £400,000 pension. You would only need to Crystallise £40,000, because 25% of £40,000 is £10,000. The remaining £30,000 (75%) would fall into the Crystallised part and, if you decided to take a lump-sum or an income from this part, it would be taxable.
After taking your £10,000 Tax-Free Cash:
In this example, you would still have access to a further £90,000 of Tax-Free Cash, but more importantly, the £90,000 could remain invested and continue to grow tax-efficiently over the long-term.
Phasing your Tax-Free Cash
There can be many good reasons to consider taking partial Tax-Free Cash lump-sums or perhaps even phasing your Tax-Free Cash to top-up your income, which means taking smaller regular Tax-Free Cash payments as income.
Phasing Tax-Free Cash would be of particular benefit to those with income subject to the Higher-Rate Tax at 40%. It may be more efficient to limit your taxable income within the Basic-Rate Tax threshold at 20% and take any surplus required as phased Tax-Free Cash.
We help our clients to look at the best way to maximise their retirement income tax-efficiently, whilst retaining as much as possible in their Drawdown Pensions to give them the best chance of continuing to grow. We also implement and administer our recommendations, because it can be extremely challenging to do so and some pension providers do not even offer this level of flexibility.
Lifetime Cashflow Modelling
We also utilise Lifetime Cashflow modelling software to help us ensure that our advice takes into consideration all aspects of your financial affairs and lifetime goals. For more information on Lifetime Cashflow modelling, read Andrew’s post ‘How does lifetime cash flow modelling work?’.
Another important consideration is the distinction between Death Benefits on Uncrystallised and Crystallised pensions. There are some compelling reasons to retain as much as possible in the Uncrystallised element of your pension, so I’ll explore this some detail in Part 2 of this article.
Of course, everyone’s needs are different and it’s important to consider how your financial decisions fit into your lifestyle. With planning, you can achieve a tax-efficient way to draw your pension income in addition to any other income sources that you may have, such as State Pensions and Rental income from Buy-to-Let properties.
All of this depends on your personal circumstances and needs, both now and in the future. There’s no ‘one-size-fits-all’ solution, so you should always seek Independent Financial Advice when considering your retirement income options.
This article simply introduces some of the considerations when taking your Tax-Free Cash. In Part 2, I’ll explore some of these areas in more detail and some other important considerations.
Update: Part 2 is now available, with seven more factors to consider when thinking about taking Tax-Free Cash from your pension.
Please remember that the value of investments and income from them may go down as well as up and you may not get back the amount originally invested. Information is based on our current understanding of taxation legislation and regulations. Any levels, bases of and reliefs from taxation are subject to change.