The option to take tax-free cash from a pension at retirement is a popular one. You may have already decided to take your full entitlement and know what you intend to spend it on.

If you have travel plans or want to make home improvements, taking up to 25% of your pension pot in one go might be a great choice.

But there are potential downsides worth considering too. Keep reading for three reasons why you might be better off not taking tax-free cash from your pension or taking only what you need.

1. Less tax-free cash means a higher regular income

If you have a defined contribution (DC) pension and you opt to take an annuity – a regular income paid to you for the rest of your life – you might choose to take tax-free cash. This is known as a “pension commencement lump sum” (PCLS), and you can take up to 25% of your pot in this way.

The regular income you receive is then purchased using your remaining pension funds. This means that the more tax-free cash you take, the less pension you can purchase and the lower your regular income will be.

There are other benefits you can add to an annuity too. These include a pension that continues to pay to your partner in the event of your death or one that rises by a set percentage each year to combat inflation.

All additional benefits will lower your purchase price, thereby decreasing the regular amount you receive. You’ll need to weigh up the need for the largest possible income, against the value of the benefits that are most important to you, including tax-free cash.

2. Your tax-free cash could lose value in real terms

If you do opt for a tax-free lump sum from your pension, you’ll need to think carefully about the amount you take. Also, be sure you know what you intend to use it for and think twice if you don’t have a plan for the money.

Whether the money is being used for a holiday or house renovations, bear in mind the budget for these activities and take only what you need, especially if you are opting for pension drawdown.

Flexi-access drawdown allows you to take income from your pension, including any tax-free cash entitlement, as and when you need it. With this option, any unused funds remain invested.

By taking only what you need, the remainder could continue to benefit from investment growth, helping to combat the impact of inflation. Remember though that the invested amount can fall as well as rise so the decision you make will need to be based on your attitude to risk.

Taking more tax-free cash than you need will likely mean that the excess amount sits in a saving’s account. With interest rates low and inflation rising, the money you don’t use could quickly begin to lose value in real terms.

3. There are Inheritance Tax benefits (IHT) to having unused pension pots

Unused pension pots can pass to a chosen beneficiary tax-efficiently in some circumstances. While the money you withdraw from your pension counts towards the value of your estate for IHT purposes, unused funds do not.

You can pass 100% of your unused pension funds to your chosen beneficiary on death before age 75. On death after age 75, any unused funds you pass on will be taxed at your beneficiary’s marginal rate.

Your beneficiary is chosen through your pension provider rather than through your will, so contact them and request an Expression of Wish form if you would like to add or amend your beneficiary.

If you expect to have other, non-pension income in retirement, leaving a pension pot until last – and only taking tax-free cash if you need to – might be a tax-efficient way to pass on your wealth.

Get in touch

If you have a specific purpose in mind and you are confident that the regular income you are due to receive is sufficient for the whole of your retirement, tax-free cash can be a great option.

Remember too, though, that taking more than you need could see it lose value in real terms.

You’ll have many decisions to make in the run-up to retirement, but Boolers are here to help. By taking a holistic view of your finances we can work with you to put a plan in place that is aligned with your retirement goals.

If you would like to discuss any aspect of your retirement plans, please contact us today.

Please note

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.