People approaching pension access age are being urged to understand the rules before taking money from their pot for the first time.
People approaching pension access age are being urged to understand the rules before taking money from their pot for the first time.(Image: Getty Images/iStockphoto)
People approaching retirement have been warned not to make rushed decisions over pension tax-free cash without understanding how the rules work.
Most people with defined contribution pension savings can usually take up to 25 per cent of their pot tax-free, up to the Lump Sum Allowance, which is currently £268,275 for most savers.
The option is often one of the first things people think about when accessing their pension, but Andrew King, pensions and retirement specialist at Evelyn Partners, said it is also widely misunderstood.
He said the 25 per cent tax-free entitlement is “probably the most treasured feature” of defined contribution pensions and can make pension saving “incredibly tax efficient and powerful”.
However, he warned that rumours before recent Budgets about possible restrictions to tax-free cash had led to concern and “some panicked decision-making”.
Mr King said: “Considering this is a well-known and jealously guarded feature of pensions, it is also widely misunderstood, with a variety of misconceptions around how it can be taken and what the implications are for the saver and their pension.”
One common mistake is assuming people only get one chance to take tax-free cash. Mr King said this is “totally wrong”, as savers may be able to take tax-free cash in stages, provided they remain within the overall allowance and have enough pension funds to support it.
Another misconception is that taking tax-free cash automatically limits future pension saving. In many cases, taking only the tax-free cash does not trigger the Money Purchase Annual Allowance, which reduces the amount most people can pay into a pension each year with tax relief from £60,000 to £10,000.
The lower allowance is generally triggered when someone takes taxable flexible pension income as well as tax-free cash.
Mr King said: “If you just take your TFC, you do not trigger the MPAA – as long as you do not also access your pension flexibly and take taxable amounts at the same time.”
He also warned against assuming tax-free cash must be taken as one large lump sum. Some savers may be able to take it in tranches, either regularly or when needed, which could leave more money invested inside the pension and help manage future tax bills.
Mr King said savers should be careful about acting purely on fears that tax-free cash could be restricted in future.
He said some people who rushed to take money before previous Budgets later regretted it after no crackdown emerged, leaving them with a large lump sum outside the tax-friendly pension environment.
He added: “Only do it if you have a well-thought out plan for it, and you are confident it will not leave you short later in retirement.”
Savers were also warned not to assume they can simply take tax-free cash and pay it straight back into a pension if rules do not change. HMRC has pension recycling rules which can apply where tax-free lump sums are used to significantly increase pension contributions.
A final misconception relates to small pension pots. Mr King said it is wrong to think small pots can simply be cashed in tax-free.
Under small pot rules, people can usually take a pension worth up to £10,000 in one go once they reach pension access age, but only 25 per cent is normally tax-free and the remaining 75 per cent is taxable.
Mr King said cashing in several small pots in one tax year could add to someone’s tax bill, especially if they are still working or have other taxable income.
He added that small pension pots should not be dismissed as “pointless”, as consolidating them and leaving them invested could help build retirement income over time.
