How to spend your tax-free cash

One key feature of defined contribution pensions is the ability to take a tax-free lump sum.

For some, this could be the most exciting part of retiring. For others, receiving what could be the largest lump sum of money they’ve ever received could feel quite daunting.

After years of saving, spending can be a big adjustment.

The information in this article is to help you understand your retirement options but it’s not personal advice. If you’re not sure if a course of action is right for you, please ask about financial advice.

What are the options?

Most people are entitled to take up to 25% of the total value of their pension as tax-free cash capped at a maximum of £268,275. The remaining value is subject to income tax at your marginal rate when making further withdrawals.

There are lots of ways to access the money in your pension and you don’t have to wait until you’ve retired. As long as you’re aged 55 or over (57 from 2028), pension benefits can be accessed.

One option is to take the 25% tax-free lump sum and move the rest of your pension to a drawdown account. The money in drawdown can stay invested and taxable withdrawals can be taken when you’re ready.

Your investments can fall and rise in value, so your income won’t be secure, and you might get back less than you originally invested.

You'll need to think carefully about the income you’ll need when you’re older. You could run out of money if your investments don’t perform as you’d hoped or you take too much income too soon. Another option is to take the 25% tax-free lump sum and give the rest of your pension to an insurance company to buy an annuity.

An annuity provides you with a guaranteed annual income for the rest of your life. The quote provided is based on several factors, including your age, lifestyle, medical records, interest rates, annuity markets and the size of your pension pot.

An annuity quote can give you a good idea as to what kind of standard of living you might be able to achieve in retirement. It can be easily compared to the salary you received whilst working.

Consider your options carefully, as you can’t usually change the terms of the annuity once it’s set up. Annuity quotes are guaranteed for a limited time only and rates change regularly.

You don’t have to decide about your entire pension all at once.

You can access a smaller portion of your pension and 25% of that portion will be paid to you as tax-free cash initially. This leaves the rest of your pension as it is, so you can access it later, again taking up to 25% as tax-free cash. If you want to get an idea of how this works in practice, have a look at our example of taking 25% tax-free cash from your pension.

Do you have to take the tax-free cash?

You don’t have to take the tax-free cash. By not taking it, you could increase the amount you receive as part of an annuity, or the money in drawdown could last longer, provide a greater income or have greater growth potential.

However, there are some important things to consider before making any decisions.

Using your entire pension to buy an annuity, or moving all of it to a drawdown account, means your entire pension would be liable to income tax. Taxable income from your pension could push you into a higher tax bracket.

Keep in mind that once you’ve made your decision to not take the tax-free cash, you won’t be able to claim it in the future.

It’s also worth being aware that once the tax-free cash is paid to your bank account, it will then form part of your estate and potentially be liable to inheritance tax for your beneficiaries.

Pension and tax rules can change and benefits depend on your own personal circumstances.

What could you spend your tax-free cash on?

Retirement is very personal.

Some people may have lots of ideas about how to spend their time and money, while others might find the adjustment to retirement difficult.

Here are some ideas about how you could spend the tax-free cash.

• Pay off outstanding debts

  This could include paying off your mortgage to reduce your outgoings in retirement.

• Live off the lump sum as though it were your income

  Budget calculators can help to understand your weekly or monthly expenditure. This could give you an idea of how long the lump sum may last. The remaining amount could stay invested in drawdown.

• Celebrate your retirement

  Many people find this period of their lives an exciting opportunity to go on holiday or travel the world, which can be funded by the tax-free lump sum.

• Support your family

  The tax-free lump sum could fund your children’s weddings, university fees or help them get on the property ladder.

• Save

  For those who feel they may not need the tax-free lump sum, it could be used as an emergency fund to increase financial resilience. Having an emergency fund that is equivalent to 1-3 years’ worth of expenditure in retirement is recommended. Emergency funds need to be accessible, the HL Active Savings service offers a range of different easy-access and fixed-term products so your cash savings can still work hard for you. If your savings rate is lower than the rate of inflation, the spending power of your money will reduce over time. Fixed term products generally only allow access to your cash at maturity.

• Reinvest

  If the money isn’t needed for the next 5 years, it could be reinvested to give you a chance of higher returns. However, unlike cash, investments can fall as well as rise so you could get back less than you invest. Investments held in a Stocks and Shares ISA are sheltered from UK income tax and capital gains tax, although tax rules can change and benefits depend on personal circumstances.

Further support

Pension Wise is the government’s free guidance service for over 50s who can offer impartial support to make sure you understand all the options available and choose the right one for you and your needs.

You could use retirement as an opportunity to seek personal financial retirement advice.