5 practical ways to make the most of your pension tax-free lump sum

You’ll always read about the advantages of paying into a pension fund, with the tax relief you receive making it a highly tax-efficient way to save money for your retirement.

However, far less attention is paid to how you should utilise the other big tax advantage associated with pensions – the fact that you can take 25% of your fund free from tax from age 55, rising to 57 in 2028.

How you use your pension tax-free lump sum should form a key component of your retirement planning.

It should be based on careful analysis of your circumstances because, regardless of your current tax status, it makes up a substantial part of your fund.

So, it’s worth thinking about using it as strategically as possible. It’s likely to be one of the largest tax-free lump sums you’ll ever have access to, so you should ensure you get the maximum financial benefit from it.

Read five ways you can make the most of your pension tax-free lump sum.

1. You can take tax-free cash and leave the remaining fund invested

In 2015, the government introduced Pension Freedoms legislation – the most radical change to pensions for decades.

The aim was to give you greater flexibility in how you take your pension benefits. One of the big “freedoms” they introduced was the ability to easily access your tax-free lump sum, without having to set up an income arrangement to do this.

You are now able to:

  • Take your tax-free cash all in one go or in stages from age 55 (rising to 57 in 2028)
  • Withdraw a mixture of tax-free cash and income
  • Vary the amount of income you take.

Importantly, accessing your tax-free lump sum alone doesn’t affect your future pension savings. As long as you don’t draw down the taxable element of your fund, you can still continue to contribute up to the maximum of 100% of your salary or £40,000 gross in a tax year – whichever is the lower amount.

Being able to access your tax-free lump sum in this way adds flexibility to your income planning and the management of your financial affairs.

2. Use it to clear debt

How you use your tax-free sum is entirely up to you, but it does make financial sense to plan ahead and take steps to ensure you’re getting the maximum benefit from it.

For example, if you have a lot of unsecured credit card debt, it may well be prudent and beneficial to use some of your lump sum to clear this. Doing so will:

  • Reduce your monthly outgoings and put your household finances on a securer footing
  • Free up money for future investment
  • Give you valuable peace of mind.

If you have no unsecured debt but still have a mortgage, you could also look to free up income by paying that off. Bear in mind that your mortgage may come with early repayment charges (ERC), so check this with your lender first before you pay it off.

Using your lump sum to reduce debt as you approach retirement can help to ensure that you can use the rest of your retirement funds to achieve your life goals, rather than having to pay lenders back.

3. Boost your investment portfolio

Using your lump sum to boost your investment portfolio could also be a beneficial step.

Having a separate fund of money alongside your pension can enhance your flexibility when it comes to your financial planning in retirement.

Given that you’ve received the money free of tax, it makes sense to ensure you pay as little tax as possible when you want access to the money you’ve invested.

One way to do this is to maximise your annual ISA allowance, sitting at £20,000 in the 2022/23 tax year. Any income you take from your ISA is free from Income Tax and Capital Gains Tax (CGT).

Remember the ISA allowance applies to each individual, so you should also ensure your spouse or partner also uses their full allowance.

4. Use it as a key part of your future income strategy

Because of the flexibility you read about in point one, you can mix income from your pension fund, tax-free cash, and other sources of income for maximum tax efficiency.

By working out how much income you require each year, you can then use your lump sum strategically alongside other allowances and investment vehicles to meet your income needs – all while keeping tax to a minimum.

For example, as you’ve already read, most income you take from your ISA will be free from tax. Additionally, you have a CGT allowance, which is £12,300 in the 2022/23 tax year. So, you can take profit from the sale of assets – such as stocks and shares not held in an ISA – up to that amount free from tax.

You also have a Personal Allowance of £12,570 in the 2022/23 tax year, so will only pay tax on income above that figure.

So, by incorporating your tax-free lump sum into your retirement income planning, alongside the other allowances outlined here, you can create an effective, tax-efficient income plan each year.

5. Keep it invested as long as possible

Unless you’re going to be using it straight away, there is little benefit in taking all your tax-free cash entitlement. Instead, you may be better off leaving it invested in your pension plan.

Some interesting research recently reported in FTAdviser revealed that 43% of those aged between 58 and 75 have accessed their 25% tax-free cash at least in part.

Of those, nearly a quarter had simply put the money in a bank account rather than investing it.

The Office for National Statistics (ONS) recorded inflation to have reached 7% in the 12 months to March 2022, and this is widely predicted to reach 9% this year. So, leaving the money in a standard bank account for any appreciable length of time will massively reduce its purchasing power.

Unless you have an immediate need, it can make more sense to keep the money invested in your pension, growing tax-free.

Get in touch

If you want constructive advice regarding your tax-free lump sum and income planning, we can help.

Email enquiries@rosebridgeltd.com or call 01204 300010 to find out more about how we could help you.

Please note

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.


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