Why you should think twice before taking your pension's tax-free cash

There are lots of benefits to using a pension to save for retirement, one of which is the ability to take up to a quarter of your pot completely tax-free from age 55. For most people, the maximum tax-free cash they can take is capped at £268,275 over the course of their lifetime.

However, just because you can do something doesn’t mean you necessarily should – and there are plenty of good reasons to think twice before taking your pension's tax-free cash as soon as you can.

This is particularly important right now, with the near-constant rumours and speculation about what tax nightmares chancellor Rachel Reeves could have in store in her Budget, scheduled to take place the day before Halloween. While these stories can be destabilising, it’s usually better to focus on your long-term retirement strategy rather than reacting to articles you read in the press.

With that in mind, here’s a quick guide to the key things you need to know about taking your tax-free cash.

How does it work?

Pension rules allow you to access a quarter of your ‘defined contribution’ (DC) pension tax-free from age 55. This ‘normal minimum pension age’ is set to rise to 57 in 2028. To access your tax-free cash, you need to choose a retirement income route for the rest of your fund. For most people, this will either be entering drawdown (where you keep your fund invested and take a steady income) or buying an annuity (an insurance product which pays you an agreed level of income for the rest of your life).

Taking your tax-free cash isn’t a decision that should be taken lightly, particularly if you are considering withdrawing the money early. You will be removing the cash from an environment where it can grow tax-free, so at the very least make sure you have a plan for it. If you just take the money out of your pension and put it in a bank account earning little to no interest, its value will quickly be eaten away by inflation.

Take, for example, someone with a £200,000 pension who decides to take their maximum 25% tax-free cash of £50,000 at age 55 and puts it into a current account paying 0% interest. If they make no further pension contributions, they will receive no further tax-free cash entitlement - even if their remaining £150,000 fund is left untouched and benefits from investment growth.

If we assume that remaining fund grows by 4% per year after charges, by age 65 it could be worth around £222,000, alongside the £50,000 tax-free cash they withdrew at age 55 (i.e. £272,000 in total). If, however, they had left their entire £200,000 fund untouched and enjoyed the same 4% investment growth post-charges, by age 65 they could have a total fund worth around £296,000, with £74,000 available tax-free. That is almost 50% more tax-free cash than if they had accessed their pot at age 55.

Understanding the ‘money purchase annual allowance’

If you have specific things you need to spend money on and your retirement pot is your only option, just accessing your tax-free cash - or a portion of your tax-free cash - can be a sensible option.

Where you also flexibly access taxable income from your pension pot, the ‘money purchase annual allowance’ (MPAA) will be triggered, reducing your annual allowance for making new contributions from £60,000 to £10,000. You will also lose the ability to carry forward up to three years of unused annual allowances from the three previous tax years. If, however, you just withdraw tax-free cash from your pension, you will not trigger the MPAA and so can retain the full £60,000 annual allowance.

If you do need to take tax-free cash from your pension, you could consider partially ‘crystallising’ some of your pot in drawdown. Crystallising in this context just means choosing a retirement income route. This could allow you to generate the tax-free cash you need, while leaving the ‘uncrystallised’ part of your pension - including the attached tax-free cash entitlement - untouched and with the ability to continue growing.

It is also worth remembering that by withdrawing money out of your pension, you are moving it from an environment where it will usually be free from inheritance tax (IHT) - and could be passed onto your beneficiaries completely tax-free - to one where it will form part of your estate for IHT purposes.

That is not to say, of course, that people should not access their tax-free cash, but simply to emphasise the importance of considering what you plan to do with the money when you access it. And whatever you do, do not let it fall victim to the ravages of inflation.