Eight questions before you take tax-free cash from your pension

The arrival of a new government has sparked questions about possible changes to tax - and changes to the rules that govern pensions, in particular.

A Pension Review is underway that will examine the whole regime for retirement savings - we’ve rounded up some of the possible changes here. One change that looks unlikely, however, is a reduction in ‘tax-free cash’ - the proportion of your pension pot that is available to access completely free of tax.

There was a kerfuffle during the election campaign when Sir Keir Starmer appeared to suggest tax-free cash - technically known as the Pension Commencement Lump Sum (PCLS) - could be up for review. This was later corrected, and Labour confirmed it saw tax-free cash as a “permanent feature of the tax system” that it had no plans to change.

Despite that, some may still have the idea that tax-free cash is under threat - and may even consider withdrawing theirs on the back of that assumption. There can be good reasons for taking tax-fee cash, of course, but there can also be dangers in doing so if you haven’t factored in all considerations.

Below are eight questions to ask yourself before you take take-free cash from your pension. For the full rules on taking tax-free cash. we have a comprehensive guide on taking withdrawals from your pension here.

1. What will you do with the money?

Taking tax-free cash without a good use for the money is likely to be a mistake. Money inside a pension is typically invested in a way that is suitable for your needs and any gains made are tax-free - although investments can fall in value too.

If you withdraw tax-free cash without a good use for it you will have to find an alternative home for it. The only way to shelter gains from tax is via an ISA but annual contributions are limited to £20,000.

2. Do you have a plan for the rest of your pot?

In order to withdraw tax-free cash, some pension schemes will require you to move the remainder of your money to a drawdown account where you will need to decide how it is invested. Do you have a plan for this money that meets your needs? If you are unsure then our Investment Pathways may be able to help.

3. Has the value of your pension pot fallen?

Taking tax-fee cash from your pension may mean that investment assets have to be sold to raise the money. If you are doing it in a rush there is a risk that you make your withdrawal after your pension pot has suffered poor performance. Taking tax-free cash at that stage risks locking in those losses and denying your pot the chance to recover its value.

4. Do you plan to pass money on after you die?

Money inside pensions enjoys some protection against Inheritance Tax (IHT), making pensions a potentially valuable way to mitigate an IHT liability. Money held in pension falls outside of your estate for IHT purposes. If you were to die before age 75 your pension can be passed to beneficiaries completely free of tax. If death happens after age 75 then the money is taxed at the recipient’s marginal rate of income tax.

Tax-free cash taken from a pension will lose these benefits and may potentially fall within the scope of IHT.

5. Will you need the money to provide income?

Money saved inside a pension is ultimately there to fund your retirement. Taking a quarter of it away will obviously reduce the potential for that money to generate an income in the future. It can still be put to good use, of course, depending on your wider financial circumstances, but it is important to understand the likely impact on your income in retirement, particularly if you are withdrawing tax-free cash some years before you plan to stop working.

It can pay to have a store of tax-free cash in the future that you can withdraw to reduce your reliance on taxable pension money, helping you to plan your income tax efficiently. A professional adviser can help with this.

6. If you are no longer working, is tax-free cash the most efficient way to access your money?

If you do not have much income from other sources, you may have unused Personal Allowance available. This is the amount we can all earn before any income tax is due, set at £12,570 for 2024/25.

If this allowance is not taken up by other earnings, then it may make sense to take a taxable lump-sum from your pension instead of tax-free cash. That’s because the taxable element will fall with the Personal Allowance and be tax-free anyway, leaving more of your tax-free cash for the future.

Consider, however, that this will then limit future annual pension contributions to £10,000 due to the Money Purchase Annual Allowance.

7. Will you break rules on pension ‘recycling’?

There are rules which prevent money being withdrawn from pensions and then contributed again to benefit from tax-relief - a practice known as ‘pension recycling’.

If you make contributions of more than £7,500 to your pension after you’ve taken tax-free cash, and those contributions represent 30% or more of your tax-free cash, then you might fall foul of the rules and a tax charge could apply. The taxman will want to know that contributions were part of your “normal retirement planning”.

The rules surrounding this can be complicated so seek professional help if you believe you may be affected.

8. Do you understand all the rules that apply?

Some occupational pension plans have rules around taking tax-free cash, including requiring you to access all of your benefits or transfer your remaining assets.

Make sure you understand all the rules governing your pension money and the ramifications of access your money.

The Government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944.

Fidelity’s Retirement Service also has a team of specialists who can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.