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By Ryan Steward FPFS, Chartered Financial Planner
As mentioned in the first blog post: you can take up to 25% of your pension as ‘Tax Free Cash’ (TFC), but one common misconception is that people think this has to be taken when they first retire, or that they have to take the full 25% in one go – in actual fact, you can take your Tax-Free Cash in stages should you need to, and often it can be advantageous to do so.
This TFC portion of your pension is tax-free even if you’re a taxpayer yourself. As a simple example, if someone is retired and has £20,000 per annum of pension income already in payment (e.g. from an existing Defined Benefit pension), and so they are already a basic rate taxpayer. This person also has £100,000 in a DC pension(s), they can take up to £25,000 as TFC and pay zero tax on it, even though they are liable to income tax due.
Outside of the 25% TFC element, the other 75% of the pension is subject to income tax, however, you still get the benefit of the Personal Allowance like you did during your working life, which is £12,570 in the 2022/23 tax year. Remember, the Personal Allowance is the amount of income, from employment, pension, or otherwise where you’ll pay zero income tax, and it gets ‘replenished’ at the start of every tax year on 6th April, so taking advantage of this can make sense for many individuals.
I’m going to cover a couple more examples that demonstrate how someone may use their Personal Allowance to their advantage, but I’ll also give an example of how not to use it. I’m including the latter example to demonstrate another common pitfall people that don’t take professional advice fall into, often costing them £thousands in unnecessary income tax. Let’s cover the example of how not to use your Personal Allowance first:
Example One – How not to use the Personal Allowance and Tax-Free Cash
Daniel is aged 62 and recently retired with £100,000 in his DC pension, he has £25,000 available as Tax Free Cash, and he has 4 years until his State Pension begins from which he’s expecting £9,000 per annum. He has no other pensions.
Daniel anticipates needing £15,000 (net of any taxes) per annum of income for the first 3 years of his retirement. In year 3 his State Pension begins payment, but also in year 3 he also ends up needing an unexpected £15,000 from his pension to make home alterations.
In this scenario all too often people will just withdraw the Tax-Free Cash until there’s none left then switch to taking income withdrawals, something like the following:
Year One
- Daniel withdraws £15,000 as tax-free cash (only) to meet his income needs for the year
Year Two
- Daniel withdraws the remaining £10,000 of Tax-Free Cash he has available in Year 2
- Daniel withdraws a further £5,000 as income (as this £5,000 is within the Personal Allowance there is no tax due)
Year Three
- The State Pension begins, paying Daniel £9,000 of income
- He withdraws a further £6,607.50 from his pension, which after taxes leaves £6,000 to give him his needed £15,000 of income
- But then Daniel needs an unexpected £15,000 (net) in this year as well. There’s no Personal Allowance remaining in the current tax year as between his State Pension of £9,000 and his £6,607.50 income withdrawal he’s already over the £12,570 Personal Allowance. As a result, Daniel has to withdraw a further £18,750 from his pension as income, which after 20% income tax gives him the £15,000 he needs to make home alterations
In this scenario, over these three years Daniel has:
- Used up all his Tax-Free Cash
- Withdrawn £55,357.50 in total from his pension, paying £4,357.50 in income tax in the process
Example Two – A better way to use the Personal Allowance and Tax-Free Cash
- Year One
- Daniel withdraws £12,570 as income up to the (Personal Allowance limit), and a further £2,430 as partial Tax-Free Cash, which gives him his needed £15,000 (net)
- Year Two
- Same as Year One, Daniel withdraws £12,570 as income, and a further £2,430 as Tax Free Cash
- Year Three
- The State Pension begins, paying Daniel £9,000 of income
- Daniel withdraws £3,570 as income from his pension at 0% income tax to use the remainder of his £12,570 Personal Allowance
- He takes the remaining £2,430 he needs as Tax Free Cash which gets him his £15,000 of income needs
- But for the unexpected £15,000 withdrawal, Daniel has only used £7,290 of his Tax-Free Cash in this scenario, meaning he still has £17,710 remaining. He can therefore take all of the £15,000 lump sum as Tax-Free Cash
In this scenario, over these three years Daniel has:
- Not used all his Tax-Free Cash, he’d still have a further £2,710 of Tax-Free Cash remaining after the end of Year Three to use in a future year
- Withdrawn £51,000 in total from his pension, paying £0 in income tax in the process
- This means Daniel has saved £4,357.50 in income tax in just the first 3 years of his retirement alone, compared to Example One
As you can see, the way in which you withdraw money from your pension can save you literally thousands of pounds in tax, it’s prudent to use the available tax bandings like the Personal Allowance to your advantage every tax year. This is why it’s a good idea to sit with a financial adviser who can get you set up appropriately, but then also guides you through and make the appropriate alterations each year going forward. The government normally likes to alter the tax bandings each year so it’s important we alter our withdrawals accordingly to make sure we continue to withdraw in the most tax-efficient way possible.
