When to take Tax Free Cash from a pension

Currently pensions may be accessed at any time from age 55 – whether you should or not depends on many factors. With Final Salary / Defined Benefit Pensions it is important to understand whether there are financial penalties applied if benefits are taken before ‘Normal Retirement Age’ which could be age 65, for example if taking benefits reduces the income paid (for life) by 4% per year – in simple terms taking benefits 10 years early will reduce income by 40%.

Understanding whether your pension is a Defined Benefit or Defined Contribution is important because some plans may be switched, and some really should not. On what basis would you decide? A tax free lump sum early in retirement might be a helpful financial boost.

With a Defined Contribution Pension if a large lump sum is withdrawn, the resulting income is likely to be less than if a smaller lump sum is taken. The tax implications can be significant. Some plans can provide what is referred to as Phased Drawdown:

For example, a basic rate taxpayer with a fund of £250,000 needs a net ‘income’ of £10,000. Following advice from his IFA, it is agreed that £30,000 of the pension fund needs to be ‘crystallised’ in order to provide this £10,000 net income. 

Firstly, a tax-free lump sum of £7,500 is generated (25% of £30,000) with the remaining balance of £22,500 moved into drawdown to provide an income. After allowing for basic rate tax*, the drawdown funds generate an income of £2,500 per annum. This results in the desired ‘net’ income of £10,000 (i.e. £7,500 + £2,500). 

If an income of £10,000 is required the following year, the policy holder will need to crystallise another lump sum in order to provide him with £7,500 net which, added to his £2,500 drawdown income, would provide him with the £10,000 total.

Eventually the option to draw tax free cash will run out, but this might correspond with the payment of State pension, therefore flexible draw down can in some circumstances be more suitable than the purchase of a taxable lifetime annuity. This example should not be taken as advice – just an explanation of one way to use a pension fund creatively.

Please note the application of basic rate tax might not be appropriate to everyone, in some circumstances a refund might be appropriate in other cases more tax might be due – always consult a qualified IFA before making decisions of this type.