Taking tax free cash
When I thought about starting to take money from my pension, one of the initial questions I had to consider was "Should I withdraw my tax free cash"?
This may not seem like a difficult question, after all who doesn't want Tax Free Cash? However when you understand a little more on how Tax Free Cash works you'll understand it's not a straight forward answer.
Most people will be aware that for a Defined Contribution pension (also known as a SIPP) that 25% of your pension is able to be withdrawn without any tax once you reach age 55 (this age is changing in 2026). This is referred to as Tax Free Cash. So if you had a pension pot of £800k, then £200k can be withdrawn without any tax. This can be very tempting indeed, but after some consideration I decided it was better to only take the Tax Free Cash when it was needed.
Working this out took numerous spreadsheets an mind wrangles, however the ultimate conclusion was relatively straightforward - it came down to charges. In simple terms, splitting money up meant the total charges on two platforms, products and funds would be overall more than the total charges on one.
Bottom line for me was - take Tax Free Cash out of the pension at the time I want to spend it, not before
Let me explain - you might want to get a drink 🤣
When taking Tax Free Cash you use up part or all of your Tax Free allowance depending on how much you take. So in the example above of an £800k pensions pot, if you took the whole 25% you would get £200k but you would use up the full 25% allowance. If you took only £20k then you've used up 2.5% or a 10% of your 25% allowance.
So if your pension gives you the option to take your Tax Free Cash allowance all at once or in smaller increments, you have to work out what's best for you. I say "gives you the option" as it does depend on the type of pension and if it has drawdown functionality.
My pension was a drawdown product, so I had the choice. So I needed to work out what would happen if the Tax Free Cash was taken in one shot or in small chunks and deposited into say an ISA.
Take that £800k pot. If you didn't take out any Tax Free Cash and you let it grow for 5 years at say 5%, then it would be worth £1,021,000 and the tax free cash element (25%) would be £255,250.
So compare that to taking the full £200k and putting it into an ISA. From a Tax Free Cash perspective you'll have used up all of your Tax Free Cash allowance. So if the rest (the £600k) grows at say 5% per annum, then after 5 years it might be worth around £765,769k and there's no more Tax Free Cash that can be taken from it as you've used your whole allowance and your ISA would be £255,256k. That adds up to £1,021,000 - the same as not taking any tax free cash at all. However keep in mind that you can't just put £200k into an ISA in one go, you'd have to drip feed it into the ISA in £20k chunks, and the growth outlined above doesn't take this into consideration - so it will actually be less.
So what happens if you only took £20k? You'll still have 22.5% tax free allowance left. So if the rest of your pot (£780k) grows at 5% for 5 years then the fund would be close to £995,500k and your unused Tax Free Cash element of that would be around £224k (22.5% of the pot). And the £20k you took out if put into an ISA would be £25.5k. That would mean overall your monies would be the same (£1,021,000) however your TFC element would be less!! The total tax free cash element would be £250k (£25.5k in your ISA and £224.5k TFC still in your pension).
So taking small amounts out to save in another place works out worse than leaving it in place, however there's more......
In the first scenario you only have one platform/product charge (the SIPP) and only one set of fund charges. As these are charges generally tiered, the more you have in them the cheaper it gets.
In the second and third scenarios you have two platforms/products (a SIPP and an ISA) so there's two sets of charges for those, and each will have their own funds charges. As you've split them off, the benefit of tiering is lost, meaning that the charges on the ISA platform/product and the funds are more than the savings you make on charges for them within the SIPP.
Bottom line, don't split up investments unless you have too and only take tax free cash when you need/want to spend it.
That said, there are some exceptions.
1. If your ISA charges are lower than SIPP charges. If this is the case then you should look at your SIPP platform charges and see if there's a better platform out there as lower charges = better value for you.
2. If you are paying for an Adviser. Advice fees are charged based upon the size of your fund, so any money you take out of the SIPP and move to an ISA would reduce the overall advice fee.
3. If the 25% TFC element inside your pension has grown beyond the LTA of £268k. In this situation the growth would not be eligible for the Tax Free Cash benefit, so moving it out into an ISA is a good idea as it means the growth within the ISA would be tax free
If you find my Hints & Tips helpful please consider Buying Me A Coffee
Comments
Post a Comment