Should I always take my 25% tax-free allowance straight away? Examples, pros and cons

When it comes to accessing your pension benefits, recent changes in pension accessibility have made it easier and more flexible than ever before. One of the most popular methods for dipping into your pension pot is by taking a Pension Commencement Lump Sum (PCLS), or as it’s more commonly known, the 25% tax-free lump sum.

But is this the most effective and efficient way to access your benefits? In this article, we’ll explore the pros and cons of taking your 25% tax-free cash immediately, and we’ll also look at alternatives like Uncrystallised Funds Pension Lump Sum (UFPLS), helping you make an informed decision about your financial future.

Pros: Immediate cash and tax efficiency

Taking the 25% tax-free allowance right away offers you immediate access to a significant amount of cash. This can be particularly appealing if you’ve just entered retirement and need to fund major expenses like home renovations, paying off debts, or even less essential expenses such as holidays and other well-earned indulgences. Having this cash on hand can provide a level of security and peace of mind, acting as a financial safety net in the early years of retirement when you might be more active and eager to enjoy life.

Another strategic benefit of accessing your tax-free cash immediately is the potential for reducing your future tax burden. When you withdraw money from your pension pot, any amount beyond the tax-free lump sum is taxed as income. By taking the tax-free portion first, you reduce the size of your pension pot which will be subject to income tax in future withdrawals. This can help you stay within a lower tax bracket in retirement, avoiding higher marginal tax rates on your income.

For example, consider Mark who has a £400,000 pension pot. Taking the £100,000 tax-free lump sum leaves £300,000 invested. Future withdrawals from the remaining amount will be taxed as income, but because he’s already taken the tax-free cash, he can spread his withdrawals over time, potentially keeping his income within a lower tax band. This approach can be more tax-efficient than taking larger taxable withdrawals later.

Cons: Reduced pension pot and growth potential

On the flip side, taking the lump sum reduces your overall pension pot, which could result in less income during your retirement years. For example, if Mark withdraws his 25% tax-free allowance for a holiday, his pension pot shrinks from £400,000 to £300,000. If he lives longer than expected or faces unforeseen costs in retirement, he might find his remaining pension insufficient to meet his needs.

Furthermore, waiting a few years before accessing your 25% tax-free allowance could result in a larger amount in the future. For instance, with a £400,000 pension pot, the tax-free allowance would be £100,000. However, if you leave the entire £400,000 invested for another five years, and the markets perform well with an average return of 5% per year, your pension pot could grow to £510,512. This means your tax-free allowance would increase to £127,628, providing you with a higher tax-free lump sum.

There is also the risk of inflation to consider. If you take the lump sum and don’t invest it wisely, or leave it as cash for an extended period, inflation could erode its value, ultimately reducing your purchasing power in retirement. 

Taxes can also have a significant impact. If you take the PCLS and plan to invest it outside of your pension, likely in a General Investment Account (GIA) or another taxable vehicle, the funds will be subject to Capital Gains Tax (CGT) and income/dividend tax, further eroding the value of your wealth. This could result in losing even more of your wealth to taxes, especially given the recent drastic reductions in CGT and dividend tax allowances.

However, if you keep your money invested within the pension, any gains are automatically exempt from CGT and dividend tax. Additionally, 25% of the pot will remain tax-free, while the remaining 75% will only be subject to income tax.

UFPLS as an alternative option

Another option worth considering when accessing your pension benefits is the Uncrystallised Funds Pension Lump Sum (UFPLS). This alternative allows you to withdraw portions of your pension without taking the full 25% tax-free lump sum in one go. Instead, each withdrawal is 25% tax-free, with the remaining 75% taxed as income.

The main advantage of an Uncrystallised Funds Pension Lump Sum (UFPLS) is the flexibility it offers. It allows you to make smaller, more controlled withdrawals while keeping most of your pension invested, giving it the potential to grow over time. For instance, with a £400,000 pension pot, if you withdraw £40,000 through UFPLS, £10,000 would be tax-free, and £30,000 would be taxed at your income tax rate. This approach enables you to withdraw exactly what you need to meet your current spending requirements, while still benefiting from the 25% tax-free allowance, unlike taking the entire PCLS, which may leave you with more funds than you immediately need.

Inheritance tax considerations

Pensions also offer a favourable opportunity to reduce your Inheritance Tax (IHT) bill. Any money left in your pension wrapper upon death is automatically exempt from IHT and will not be subject to the 40% tax charge on your total assets over the value of £325,000. If you pass away before the age of 75, your entire pension pot could be passed on as a completely tax-free lump sum to your beneficiaries. If you pass away after 75, the pension would be taxed at your beneficiaries’ marginal rate of income tax. Therefore, drawing upon other assets before your Pension in retirement could lead to a greater proportion of your overall wealth being invested within the Pension wrapper at your time of death, which will ultimately reduce your IHT bill.

For example, consider an individual with £800,000 in assets who dies at age 70. The IHT threshold is £325,000, and tax is charged at 40% on anything above this. The taxable estate is, therefore, £475,000 (£800,000 – £325,000), leading to an IHT bill of £190,000 (£475,000 x 40%). 

However, if the individual had £400,000 of their total estate invested within the pension wrapper, the portion liable for IHT would reduce to £400,000 (£800,000 – £400,000). This would result in a taxable estate of just £75,000 (£400,000 – £325,000), leading to an IHT bill of £30,000 (£75,000 × 40%). Thus, holding a larger portion of one’s estate within a pension can significantly reduce a future IHT bill.

Conclusion: Weighing up your options

The decision of when to access your 25% tax-free cash ultimately depends on your individual circumstances and financial goals. While the immediate benefit of having cash in hand is appealing, it’s essential to consider the long-term impact on your pension pot, potential tax efficiencies, and the effect of inflation. Taxes can significantly erode the value of your wealth over time, especially if large withdrawals push you into higher tax brackets or expose you to capital gains taxes, or increase your IHT liability by having funds held unnecessarily outside of the pension wrapper. Additionally, exploring alternative options like UFPLS may offer greater flexibility and tax control, allowing you to keep your pension invested longer and giving you more control over when and how much you withdraw.