Since the new pension freedoms came into effect last April, people planning their retirement have had greater choice in how they access their pension pots once they reach the age of 55. One option which some people have chosen is to take the 25% of their pension pot which they are allowed to access tax-free before leaving the rest – the taxable bit – untouched, either to draw down or buy a guaranteed income at a later date.
What to think about before deciding on this option
- It could make sense not to take the taxable part until your tax rate falls – for example, when you give up work.
- Even if you’ve taken the tax-free cash, that doesn’t mean you need to stop investing.
- At some point you will begin to draw on the remaining 75% using one-off or regular withdrawals (more on this later).
- How to invest the rest – this depends on when and how you take the remainder of your pension pot.
Tax-free now, the rest later
Another popular option is to take the tax-free lump sum but leave the rest to a later date.
This option is useful for people who still have other taxable income, because the tax-free lump sum doesn’t increase their income tax bill. The money withdrawn could also come in handy for helping children with university costs or a deposit to buy a house and for repaying debt.
Another reason why some retirees choose to leave taking the taxable part until a later date is the fact that many people pay a lower rate of tax in retirement than they do when they are working. For example, it’s estimated that six out of seven people who pay 40% income tax when they are working will end up paying only basic rate tax when they retire.
Think why you might need the tax-free cash
There’s no need to take your tax-free cash unless you actually have a use for it. Taking a tax-free lump sum out of your pension to place in a bank deposit or ISA doesn’t usually make good financial sense. Pensions, like ISAs, are tax efficient, but they are also generally free from inheritance tax, whereas bank deposits and ISAs will form part of your estate when calculating any inheritance tax due.
The range of investments available via modern pensions is similar to stocks and shares ISAs and you will be able to invest in hundreds or even thousands of funds managed by investment managers. You may also be able to invest in bank deposits or individual shares and government or corporate bonds through your pension.
Keeping the tax-free lump sum invested may also mean that you will be able to draw a bigger lump sum later if your investments do well – although they can, of course, also go down in value.
The option to carry on investing
You should also consider continuing to invest into your pension if you can afford to do so, and particularly if you are employed. By 2018 all employers must pay into their employees' pension scheme if they are over 22 and earn more than £10,000pa. So you could say that leaving your pension scheme is like turning down free money. If you’re in your employer’s pension scheme, make sure you know how much you need to pay in to get the maximum employer contribution.
Continuing to invest more also means you will build up another tax-free lump sum that you can take at a later date.
The remaining pension
You can leave the remainder of your money invested in your pension. You should consider if your current investments are right for you to achieve your retirement goals. This will depend on when you plan on accessing the remainder of your pension pot and how. Consider how long you intend to leave the money invested, your attitude to investment risk and your ability to absorb any loss should this occur. You may well decide to take different investment strategies for any short and medium to longer term goals.
Other ways to access your pension pot
As an alternative to taking a tax-free lump sum and leaving the rest of your pot, you might choose to:
- Take withdrawals from your pension pot as and when needed, in a combination of taxable and tax-free cash.
- Take a regular income through buying a guaranteed income for life, known as an annuity.
- Take tax-free cash and then arrange regular withdrawals directly from the remaining pension pot (known as income drawdown).
You can read about taking withdrawals from your pension pot as and when needed on page X. We will consider income drawdown and annuities in future editions of Thinking Ahead. But in the meantime you can visit, ’How do I take an income from my pension fund?’ on our website.
What else might you do?
For other ways of accessing your pension, see: