Savers aged over 55 are scrambling to extract their tax-free lump sums from pensions because they fear the limit will be slashed in November's Budget.
Others are acting ahead of the Government's plan to levy inheritance tax on pensions from April 2027. But new research reveals that savers who take a lump sum (even if they don't need to spend it) could risk running down their pot sooner than necessary. Murphy Wealth crunched the numbers to see how much taking a tax-free lump sum could cost a typical saver instead of leaving it longer to grow. For example, take a 65-year-old with a typical retirement pot of £362,400 to invest after a 40-year career earning the average median salary of £37,430 and paying the minimum into their pension each month. They would be able to take a 25 per cent tax-free lump sum of £90,560 - not far off the average tax-free withdrawal of £85,780.
If they took £85,780 and then used the rest of their pension pot to top up their state pension income to £31,700 after tax a year, they would drain their pot by the age of 77. An income of £31,700 will give you a moderate retirement lifestyle, according to industry calculations. But if they put off taking the lump sum, then assuming investment growth of 5 per cent their fund could potentially last until age 84 - an extra seven years. Of course, almost everyone will want to take their tax-free lump sum eventually, but this illustrates how you can benefit from investment returns on the money left unspent. The longer you leave money in a pension, the longer it has to grow. The minimum age you can start accessing private pensions is 55. You typically have the option of taking up to one quarter of your money as tax-free cash up to a cap of £268,275, while the remainder is used to secure a taxable income for the rest of your life.
Another option
There is also another approach to taking tax-free cash from invested pensions, and it's a valuable trick which potentially allows you to squeeze more than 25 per cent tax free cash from your fund - if you are patient and invest successfully. You are not limited to just one chance to take a tax-free lump sum worth 25 per cent - instead you can benefit from untaxed chunks over multiple withdrawals throughout your retirement. Each chunk you take will be 25 per cent tax-free and 75 per cent taxed at your marginal rate. The marginal rate is whatever tax band you are pushed into once all income, including withdrawals from your pension, has been counted. Every time you take a chunk, you'll receive 25 per cent of your pot tax-free. If your pot continues to grow, that 25 per cent can also increase in value over time.
Say, for example, you have a pot worth £100,000 and take £10,000 in one year. Of this, £2,500 would be tax-free and £7,500 would be taxable. The remaining £90,000 would stay invested. If you enjoyed investment returns of 5 per cent the following year, your remaining pot would now be worth £94,500. Then, if you subsequently took 25 per cent of your £94,500 tax free, you would get £23,625 - £1,125 more than if you'd taken the full tax-free lump sum from the start. However, you lose this tax-free perk if you tie up your entire pot in an annuity or income drawdown scheme. You therefore need to check that the bulk of your pension cash is 'uncrystallised', with either your current pension provider or anywhere else that you transfer it.
Final salary pensions
The rules are different for final salary, or career average defined benefit pensions, which provide a guaranteed income for the rest of your life. Unless you work in the public sector, these have been mostly replaced by defined contribution pensions. But many people nearing retirement will have accrued benefits before the schemes were closed. You are allowed to take anything up to 25 per cent tax free. But the bigger the lump sum you withdraw, the more future pension you sacrifice - and some schemes force you to forfeit more than others.
What you give up is down to the 'commutation factor'. For example, you might be offered £12 in the form of a lump sum for every one pound of future pension you give up. This is a commutation factor of 12:1. But some schemes will offer you £20 of lump sum for every pound of pension income you sacrifice. That would be a far better commutation factor of 20:1. Steve Webb, from pension consultants Lane Clark & Peacock, says: 'In some cases, in a defined benefit pension scheme, the lump sum on offer is on a take-it-or-leave-it basis. But in other schemes you can choose the combination of tax-free lump sum and regular scheme pension.' The tax-free lump sum is available when you start drawing a defined benefit pension, but not later on.
Leaving it untouched?
Of course, the decision is not as simple as leaving your tax-free lump sum untouched for as long as possible. Some people have specific plans for their money, such as clearing debts or a special holiday. Deciding to hold off means banking on the rules not changing - a risk, although tax-free cash was left alone at the last Budget, and so far there is only speculation that the Chancellor could act this year. 'It's important not to act on rumours - we do not know what the Budget will hold and once you have removed money from your pension, you cannot put it back in,' says Murphy Wealth boss Adrian Murphy.
Alice Haine, personal finance analyst at Bestinvest, says: 'Taking tax-free cash prematurely as a reaction to a possible policy change can undermine retirement plans and prove to be tax inefficient.' Others may not want to wait, says Steve Webb: 'If you have an urgent need of capital now, perhaps to clear debts, then the balance might shift. You also need to think what pattern of spending you will need through retirement.'