What’s the best way to use my 25% pension tax-free cash?

If you don’t really need the money right now, consider whether you may be better off leaving your 25% tax-free cash in your pension to benefit from future potential growth. 

Tom Selby, head of retirement policy at AJ Bell, said: “There is no ‘best way’ to use your tax-free lump sum, but it’s important to think carefully about what you want to do with the money, rather than simply taking it out of your retirement pot at the first opportunity.

“In fact, there are potential benefits to leaving your tax-free cash within your pension for as long as possible. Firstly, any growth your fund enjoys within a pension will be completely tax-free. 

“Second, if your fund does grow, then the tax-free cash entitlement attached to it will grow as well – although of course investment returns are never guaranteed and can be volatile, particularly over the short-term. You also need to remember that your pension fund needs to support you throughout retirement, so taking out a quarter and spending it frivolously could leave you on a sticky wicket further down the line.”

Leaving your tax-free lump sum invested in your pension may be particularly beneficial if your investments have fallen in value, as they could benefit from future stock market gains, and leave you better off later in retirement. 

For example, if you have a pension valued at around £200,000, you’re able to take up to £50,000 as tax-free cash. If your pension grows in value by about 4.5% a year for the next 10 years, your pension will be worth about £325,779 (before charges) and you’ll be able to withdraw a tax-free lump sum of about £81,000. 

This would see you not only benefit from investment growth, and a larger tax-free lump sum, but also save money in income tax on your remaining pension withdrawals. However, your pension investments may fall as well as rise in value, and no-one can be sure how investments will perform, and they may fall as well as rise. Read more in our article Should I take my tax-free pension cash at 55?

Bear in mind, too, that currently pensions can be passed on completely free of Inheritance Tax (IHT), and completely tax-free if you die before age 75. If you die after the age of 75, your pension will be taxed in the same way as income when your beneficiary (or beneficiaries) come to make a withdrawal. However, this is set to change in April 2027, when pensions will fall into the inheritance tax net for the first time. Learn more in our article Can my pension be used to reduce inheritance tax?

Gary Smith of Evelyn Partners said: “For those who are looking at substantial IHT liabilities after pensions are included in estates, taking out whole of life cover can be an efficient way of insuring your inheritance tax liability, so beneficiaries do not have to pay it themselves.

“You can take out a life insurance policy for all or part of the estimated IHT bill and crucially, have it written into trust so the eventual payout does not form part of your estate for tax purposes. You pay the monthly premiums and when you die the trustees (your beneficiaries) can use the proceeds to promptly settle the IHT bill.

“These policies can be expensive but if someone has a lump sum they want to use, they could park some of it as a fund to pay premiums that might span many years and really mount up.”
Learn more in our guide How to protect your life insurance from inheritance tax.