How to guide: Lifting your tax-free cash
As a result of the pensions freedoms introduced in April 2015, there is now much greater freedom as to how and when you can access your pension pot. It’s no longer a necessity to purchase an annuity (basically a type of insurance that will give you an income for life) – although this still remains an option if you wish. Instead, you can now access your pension from age 55 – either taking it wholly, making regular or ad hoc withdrawals or keeping it invested until later.
More importantly, this means that from the age of 55 you can now take 25% of your pension tax-free. By entering into drawdown and crystallising all or part of your fund, you can take up to 25% without any tax penalty.
For many, this process of flexibly accessing your pension – via pension drawdown – may already be something you have carried out yet as a result of the complex rules and jargon may be something you still do not fully understand. Indeed, drawdown can be a great choice for your retirement, but with the flexibility of drawdown comes extra complexity.
That’s why I’ve put this short article together to explain the main process involved in pension crystallisation, the different options available for you and what the benefits of this are.
What does crystallising my pension mean?
A pension is effectively a protective tax wrapper, and when you take money out the tax status of the pension is altered. Benefit crystallisation therefore occurs when you choose to take money from your pension and is the process of measuring the benefits against your remaining lifetime allowance – if exceeded, a lifetime allowance charge will be imposed.
When you crystallise all or part of your pension, 25% of the money becomes tax-free while the remaining 75% is taxable at your marginal rate when you chose to life the income. This means that if you crystallise £40,000 of your pension pot, £10,000 can be then lifted tax free. In other words, if you wanted to lift £10,000 tax-free cash, you would have to crystallise £40,000 of your pension.
Do I have to lift all of the money that is crystallised?
No, if you chose to crystallise £40,000 of your pension pot, this doesn’t necessarily mean you have to lift the entire £40,000 and pay tax on the remaining 75% (£30,000) – a particularly daunting thought if you are currently a higher rate taxpayer. You can keep the taxed element in your pension, where it will remain outside your estate for inheritance tax purposes. You pay tax on this money only when you take it out of your pension.
In practice you will then have both "crystallised" and "uncrystallised" money within your pension. This could be invested in identical ways. The difference is that the "uncrystallised" cash will still have a 25% tax-free element from which you can benefit in future.
Can I lift less than 25% tax-free?
It isn’t possible to take less than 25% of your pension tax-free. For example, say you wanted to lift £8,000 from your pension pot and only lift £1,000 tax-free as your currently paying little tax just now but expect to be paying more in the future – this would not be an option. If you want to lift tax-free money from your pension, it has to be 25% - meaning £2,000 tax-free cash would have to be taken in the example above.
What are the benefits of pension crystallisation?
For those who may require a large lump sum of money before they actually retire ie, to put towards a daughter’s wedding or provide a deposit for a child’s first home, the 25% tax free lump sum can be a great way of gaining access to this money without paying hefty tax bills – particularly if you’re a higher rate tax payer.
You should be aware however that just because you are allowed 25% of your pot tax free, this doesn't mean it is a good idea to crystallise your entire pot and lift the 25% tax-free amount at the one time. If you were to take a large lump sum and pass away suddenly, that money will fall within your estate and your beneficiaries could therefore have to pay inheritance tax on it. But if it were still in your pension, it would be outside the estate and therefore free of inheritance tax.
The scenario below should help to illustrate this:
Mr Joe Bloggs has £500,000 in his pension pot and wishes to lift £10,000 tax-free cash to pay towards his daughter’s wedding. He is currently a higher rate tax payer and wishes to take £25,000 per year from his pension pot once he retires.
By entering into flexi-access drawdown and crystallising £40,000, he can lift 25% (£10,000) tax free and keep the remaining £30,000 invested in his crystallised pot where it can continue to grow. By keeping this invested until he retires, this will help to reduce the amount of tax he will pay when lifting it (20% as opposed to his current 40% rate). The money will also remain out-with his estate reducing any potential IHT.