Some of the most important retirement decisions you will have to make are if, when, and how you take your tax-free cash lump sum.

This decision is very important, but the consequences can be even more far-reaching during periods of economic uncertainty. 

Keep reading for just a few of the factors you’ll need to consider. 

Multiple factors have combined to create market instability

Over the last couple of years, the markets have battled against a combination of destabilising influences.

The coronavirus pandemic led to increased borrowing while global supply chain issues, labour shortages, and China’s zero-Covid stance slowed economic recoveries. These issues were exacerbated when Vladimir Putin invaded Ukraine, causing intense suffering and rippling economic issues for countries reliant on Russian oil.

More recently, Kwasi Kwarteng’s “fiscal event” saw market confidence evaporate as the value of the pound against the US dollar dropped to its lowest point since decimalisation. 

All of this has a bearing on your pension and how you decide to take your tax-free cash lump sum.

Taking your tax-free cash entitlement

Tax-free cash from an annuity

When you take an annuity from a DC scheme you’ll usually be entitled to up to 25% tax-free cash. This is known as a pension commencement lump sum (PCLS). As the name suggests, it is paid at the point the annuity comes into payment.

Once a pension basis has been selected, it can’t be altered. You’ll need to think very carefully about whether to take tax-free cash or not and if so, how much. 

Tax-free cash and Pension Freedoms

When Pension Freedoms legislation came into force in 2015, it greatly increased retiree flexibility. 

You can now take all of your pension pot as a lump sum, in one go. Your 25% entitlement will be paid tax-free, with the remaining 75% taxed as income. You might also opt to take smaller lump sums throughout your retirement (up to your 25% entitlement) as and when you need them. 

As with all other pension options, there is no one right choice, and the best course of action for you will depend on your circumstances.

3 key factors to consider before you take tax-free cash 

There are pros and cons to a PCLS and using Pension Freedoms legislation. Think carefully about the following factors:

1. Do you have a large amount of cash already earmarked?

If you have big plans for the early, active years of your retirement – like house renovations or world travel, for example – these could prove costly. 

If you need access to more than 25% of your pension value (and you have other income streams to see you through retirement) you might opt for a full lump sum, known as an “uncrystallised fund pension lump sum (UFPLS)”.

You’ll receive your whole pot in one go but bad timing could cost you so you’ll want to keep a close eye on markets. You could also push yourself into a higher tax bracket or end up paying emergency tax. While any overpayment can be claimed back, this may take time. 

You’ll need to consider these factors, especially if your plans are time-sensitive. 

2. What will you do with the excess if you take more tax-free cash than you need?

As you might have seen back in July, when we looked at 5 compelling reasons to factor rising inflation into your retirement planning, rising living costs and low savings rates can affect the value of your money over time.

If you take more tax-free cash than you need, the excess is likely to sit in your cash savings. With inflation high and savings rates low (despite the Bank of England’s seventh consecutive base rate hike), your money will be effectively losing value in real terms.

Using flexible options like drawdown might allow you to manage your tax-free cash more effectively, taking out only what you need, at the point when you need it.

3. Could factoring in market performance now help you in the long run?

When you first start saving for retirement, you are said to be in the “accumulation phase”. You can afford to take a certain level of risk because your pot will have time to recover from short-term blips. 

As you get closer to retirement, though, you’ll want to consolidate the gains made during the accumulation phase. Moving some of your pot into lower-risk funds shields you from big losses. But timing still plays a massive part.

You might have your heart set on a specific retirement date but it’s worth thinking about how flexible you can be. Taking a large lump sum when markets are low could “lock in” that lower value. 

If the markets make a recovery when your pot has already been diminished, what might that mean for your retirement? Could taking bite-size chunks of tax-free cash mean leaving more of your fund invested, with the potential for greater growth when markets rise?

Deferring your pension could be a viable option if you have retirement income coming in from elsewhere. 

Get in touch

Retirement decisions are never easy and the consequences of them can be far-reaching. That’s why we are here. Whatever aspects of your long-term retirement plans are worrying you in the current climate, if you need help, get in touch. Email info@thepensionplanner.co.uk or call 0800 0787 182. 

Please note:

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.