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Should you take your 25% tax-free lump sum?

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This content is for information purposes only and should not be taken as financial advice. Every effort has been made to ensure the information is correct and up-to-date at the time of writing. For personalised and regulated advice regarding your situation, please consult an independent financial adviser here at Castlegate in Grantham, Lincoln or other local offices.

Since the 2015 Pension Freedoms were introduced, those with a pension pot in 2021-22 can now withdraw up to 25% of its value once they reach age 55. For someone with a £500,000 defined contribution pension, for instance, up to £125,000 could be taken out and used for any purpose you like – such as a house extension, a new car or clearing the rest of your mortgage debt. However, just because you have the option to take out 25% of your pension’s value, does that mean you should?

In this article, our financial planning team at Castlegate here in Grantham offers some thoughts on this important question. We hope you find this content helpful. If you would like to discuss any of these matters or discuss your own financial plan with us please get in touch to arrange a no-obligation financial consultation, at our expense:

01476 855 585

Why can you take 25%?

Retirement used to be a lot more regimented in the 1990s and before. If you did not have a final salary pension and spent your career building up a pension pot, then you were usually required to use the funds to buy an annuity when you retired (a financial product paying out a guaranteed lifetime income). Since 2015, however, the UK government has used Pension Freedoms to bring much more flexibility to how people can spend the money they have saved for retirement. For instance, it is now possible for someone aged 55 (or over) to withdraw, say, 10% of their pension pot to settle a longstanding debt – whilst keeping the rest invested and providing an income using flexible drawdown.

Reasons to take 25% from your pension

There can be many compelling reasons to consider taking up to 25% from your pension pot(s) after the age of 55. Tax mitigation can play an important role, in particular. If your projected income in retirement places you in the higher rate income tax bracket (40%), then taking up to 25% as a tax-free lump sum could be more tax-efficient, assuming you can live comfortably on a lower income in retirement.

Another reason to consider a large pension withdrawal concerns taxes upon your death. Whilst the UK tax system currently exempts any defined contribution pension pots from inheritance tax (IHT), this may not always be the case in the future. Government policy might change, and IHT could be an area where politicians seek to raise more money for the Treasury. Even if this does not happen, however, taking up to 25% from your pension could still help with your estate planning. Remember, your heirs pay no tax on any pension money they inherit from you if you die before the age of 75 (under 2021-22 rules).

Reasons to not withdraw

With all of this said, it is important to not impulsively take any of your 25% tax-free lump sum without some very careful thought – ideally, in discussion with a financial adviser. First of all, in many situations, taking savings and investments out of your pension could lead to a higher IHT bill later on. For instance, suppose you take 25% from your £300,000 pension (i.e. £75,000) and hold it in a regular savings account, an ISA and a general investment account. If you suddenly died, then this amount would likely be subject to IHT.

An even more crucial reason to think carefully before making a big pension withdrawal is that doing so could lower your income in retirement. This is because, with less money invested, your pension pot will likely be worth far less by the time you retire compared to if you had not taken out 25%. In the worst-case scenarios, this could lead to pension poverty or even running out of money in retirement. If taking up to 25% from your pension now, tax-free, could result in your monthly income reducing significantly in retirement (e.g. £100s), make sure you seek financial advice before you act. It’s also important to bear in mind that keeping your pension invested can open up flexibility and options for you later. For instance, you could delay the purchase of an annuity, or choose to take a tax-free lump sum when market prices are higher. Remember, you do not have to rush to make a large pension withdrawal once you reach age 55.

Conclusion & invitation

If you are interested in discussing your own financial plan or protection strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:

01476 855 585