A question that I keep getting asked right now is, should I take my pension tax free cash?
The rumours are rife that Labour may do something with pensions when their first Budget comes round on the 30th October 2024.
We know they plan to raise money from somewhere to plug the so-called ‘fiscal black hole’ so could they really reduce or even remove the 25% tax free lump sum?
If they do indeed plan to do something with the tax free lump sum it may prompt you to cash it in now before you lose the chance to. But is this a good idea.
Let’s look at what the government might do and the pros and cons of taking your pension tax free cash now.
What could change with the pension tax free cash
We know the new Labour government plan to raise taxes following Chancellor Rachel Reeves speech regarding the £20billion black hole.
We also know they have committed to not raising the three big taxes, Income Tax, National Insurance and VAT.
So that doesn’t leave them much else to raise significant funds and therefore seems likely that something could be done with pensions.
In terms of pensions, they could:
- Reduce Income Tax relief on contributions.
- Bring back the Lifetime Allowance.
- Raise the minimum age for accessing your pension.
- Make pensions subject to Inheritance Tax.
- Reduce or remove the pension tax free lump sum.
Focusing on the last point, the tax free lump sum or the Pension Commencement Lump Sum (PCLS) to give it its proper technical name, let’s just remind ourselves of how this currently works.
When you reach minimum pension age, 55 changing to 57, currently you have the right to access and withdraw money from your private or workplace pension.
One of the options you have when you want to make a withdrawal is to take up to 25% of your uncrystallised pension as a lump sum that is tax free.
You don’t need to take the tax free lump sum all in one go, you can phase this over a longer period of time.
For example, say your uncrystallised pension (meaning you have never withdrawn from it) is £1million, you could crystallise £40,000 every year, £10,000 of which would be tax free (25%) and the other £30,000 would be subject to Income Tax.
There is already a cap in place that limits the total amount of tax free cash you can take over your lifetime. The current Lump Sum Allowance is £268,275. You may be entitled to a higher allowance if you have some form of Lifetime Allowance protection.
So, the easiest thing for the government to do would be to reduce the Lump Sum Allowance cap. This may not raise that much tax for the government though.
If they were to reduce it or remove the ability to take a tax free cash lump sum altogether this could trigger a number of problems for the government.
For a start it could get very complicated. Lots of retirees would have already taken some tax free cash but not all of it. Others will be just about to retire and have planned to use their tax free cash in a certain way.
All this could mean bringing in some form of protections like governments have done in the past when changes to the Lifetime Allowance were made.
It could also wind up those in the public sector that also benefit from the tax free lump sum when taking their pensions.
We have seen in the past that when pension contributions have been restricted, Doctors and Nurses ended up leaving the NHS to avoid big tax bills.
If the government were to announce a removal of the tax free lump sum and give people time to prepare, it could cause a big sell off in the stock and bond markets as people rush to get their money out of their pension. It could also lead to a number of people leaving the workforce as they bring forward their retirement.
On this basis, if they were to do something as radical as removing the tax free lump sum, they will probably need to do it midnight the day before they announce it.
Pros and cons of taking your pension tax free cash now
So, if you are concerned about the potential reduction or removal of the pension tax free lump sum and do decide to take it now what are the advantages of doing this?
Well firstly it provides you with a significant amount of cash in your bank account without paying any tax on it initially.
This could be an efficient way to release funds if you are already still working and are a higher rate taxpayer. If you can’t take any money out of your pension tax free, you are going to be paying a lot of tax on any lump sum withdrawals.
Having access to a tax free lump sum now could give you the ability to take early retirement as you may be able to live off the tax free lump sum for a while.
Part of this process could be to pay off the remaining amount of your mortgage using the tax free lump sum or you could make a gift to you kids and help them out in some way.
The key advantage is that by taking the tax free lump sum it gives you options.
There are however a number of disadvantages if you did decide to take your entire tax free lump sum now in one go.
Remember there is no guarantee the government will make any changes to the tax free lump sum. We are only working on rumours.
If you were to take it and they didn’t make any changes then you would have lost the ability to take a greater tax free amount in the future. This is because the tax free lump sum is a percentage. So, if your pension pot grows in value over the next few years, you may be able to take 25% of a bigger pot.
Once you take your entire tax free cash you cannot take anything further from your pension tax free. All future withdrawals will be subject to Income Tax.
Once you have taken your tax free cash, if you don’t actually need it, the next problem you have is what to do with it. Where do you park it?
A bank account? This means you might end up paying tax on the interest earned if it’s outside an ISA or Premium Bonds.
It’s then likely to lose value in real terms due to the impact of inflation.
Currently, pensions are free from Inheritance Tax. By taking the tax free lump sum you are bringing this money back into your estate and therefore potentially subject to Inheritance Tax on your death.
You could be losing out on a greater retirement income in the future as you would have less money in your pension pot. Less money to grow and less money to take.
Ultimately, we just don’t know what is going to happen at this stage and we can only make educated guesses.
I would suggest that if you were going to take the tax free lump sum anyway and you have a plan for it that fits your overall goals then you might want to do this sooner rather than later.
However, if you don’t need the pension tax free lump sum and have no plans for it for a number of years then you are probably best to leave it where it is and see how this all plays out. This latest government’s term may only be five years by which time a new government could come in and it be all change again.
If you would like to stress test your retirement plans or even to get a plan in place then please get in touch for a free no obligation 15-minute call. We would be happy to review your position, explain where you stand and what you need to do to get the outcome you desire. We have created hundreds of happy and protected retirements over the years. This could be you too.
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