Tax Free Cash - What is it ? How Does it Work ?

Many people are aware that they will receive a tax free lump sum when they take their pension. The lump sum is typically 25% of the whole fund value. For example, if their pension fund is worth £150,000, then they could receive a tax free lump sum of £37,500.

Many people however are loath to take this lump sum as they believe they will also have to start taking a monthly pension income. Some Pension contracts do insist that you have to take an income if you take your tax free cash, but there are other options open to you. If you are aged 55 and still many years from retirement, taking an income from your pension is unlikely to be a good idea.

Changes to the pension rules in April 2006 made it far easier for people to take the lump sum from their pension, while leaving the rest of the pension in place to take when a monthly income does become necessary.

If you are aged between 55 and 75, we can help you realise a lump sum from your existing pension fund. You can also decide whether to take no monthly income, an enhanced monthly income or somewhere in between.

Tax Free Cash - How to do it

Unlike an annuity, you do not exchange your pension fund for cash and income. Instead you leave the fund invested and take the tax free cash directly from the fund. The rest of the fund remains invested in exactly the same way as your current pension fund. This means it is exposed to the ups and downs of the investment market.

This approach has a number of benefits and some risks, all of which we will explain in the “What you need to decide” section at the bottom of this page.

If this all becomes too confusing for you, call us on 0845 83 87 811 and one of our trained member of our team will give you all the information you need in simple easy to understand language.

Many people get confused about Drawdown, so let us try to make it simple for you:

You may currently have a personal pension, which you may or may not contribute towards. That pension fund is invested in one or more funds of your choice. Hopefully with prudent fund selection over time your pension fund will grow.

A drawdown pension contract works in exactly the same way.

Things only change when you decide to take your lump sum and / or some income. This is known as “taking benefits” and therefore “putting the pension into Drawdown” or "Crystalising Benefits".

At this point you can no longer contribute to this pension contract. However you can contribute to any other pension fund that is not in Drawdown.

When you take the benefits from a Drawdown contract, the tax free cash will be taken directly from the fund. The contract also assumes that you want to take an income, but if you are only interested in your tax free lump sum, you can select to take zero (0%) income. This means that the remainder of your fund remains invested, and so has the potential to grow.

If you are interested in taking some income as well as your tax free cash, then please see the Slow Start Annuity page.

The concept of leaving your pension fund invested after taking tax free cash can be a potential benefit.

There are also significant risks associated with Income Drawdown contracts, which are discussed in more detail below, however you should remember that taking money from any retirement product before retirement can seriously erode your income in retirement.

Income Drawdown contracts are very sophisticated products. As standard we provide Income Drawdown without advice. If you are at all uncertain about Income Drawdown if you do not fully understand the various features and risks of the product, we strongly recommend you take financial advice.

This chart demonstrates what would happen to a pension fund of £100,000 that was put into drawdown by a customer aged 55 and grows at a rate of 5% per annum.

The chart is based on a quote provided by Winterthur (who are part of AXA), it assumes a commission of 1%*, with an annual management charge of 0.5% and a fund management charge of 0.8%. These figures are for illustration purposes only and are not guaranteed. The value of your fund could go down as well as up. If these charges were higher, then the projected growth would be lower.

Even in a scenario where investment growth replaces the amount you took an a pension lump sum, you cannot use that growth to take a further lump sum.

As you are nearing the point where you need a retirement income you should consider making use of the cash or deposit pension funds which are made available to you by drawdown providers. These funds should give returns similar to bank or building society deposits. While you won’t see exceptional growth it should protect the value of the fund, if there were a stock market crash. If the product charges are higher than the return you got from a cash or deposit fund then the value of your fund would decrease. However many people may consider this a price worth paying to protect the overall value of the fund just before retirement.

If while you were in cash or deposit funds there was exceptional stock market growth, this growth would not be reflected in your fund.

After taking your tax free lump sum you can, at any point, start taking income from the fund. You can either do this by drawing it down from the Drawdown pension itself (see slow start annuity), or you can use the whole or part of the fund to take a conventional Pension Annuity.

We are also able to offer you a Drawdown contract which would offer you 100% protection of your capital and a guaranteed return if you are willing to leave your fund completely untouched for a set term. The minimum term is three years or you could chose any other term as long at the maturity point was not after your 75th birthday. For more information and quotes on such a contract please contact us on 0875 83 87 811.

We will look at your existing pension arrangements and see what options are available to you. It may be that your existing provider will offer you a drawdown option; you may have to transfer; your fund size may exclude certain providers from offering you a drawdown contract.

We will provide you with a report on the product you select. This information only report explains the features of your selected product including the associated risks. We provide this information because we want our customers to make an informed decision.

Upon receiving your instruction, we will ask for your permission to contact your existing pension provider to obtain an annuity quote.

We will ask you to give us written authority to speak to your existing pension provider to see if your pension contract has any special conditions which could indicate that it is best for you to stay with your existing provider. Without this written authority, your pension provider will not be able to give us specific information about your pension.

We will make you aware of what your existing provider is offering so that you can make an informed decision.

We can of course obtain quotes purely based upon the information you provide. In such cases we are sure you understand that we could not be held responsible if you moved away from a pension that offered enhanced rates or guarantees.

We will then need to get an understanding of the features you require from your pension. Obtaining this information from you should not take more than a few minutes.

The most important decision you will need to make is whether it is right to take a tax free lump sum from your pension fund before your retirement age. Remember taking money from your pension fund before retirement could seriously erode your income in retirement.

This is an irreversible decision, you will not be able to reverse the decision at some later point or take a further tax free lump sum.

Once you have made that decision, we are more than willing to help you.

There are, of course, a number of benefits and risks in taking this course of action and we will highlight them below.

By keeping your pension invested, you have the opportunity to manage your investment options until you want to purchase an annuity. A good investment strategy could not only replace the amount withdrawn from the fund, but even grow the fund.

At the point you want to take an income, you have a number of options, including full or partial pension annuity or taking an income from the Drawdown fund.

Even if you don’t want any income at the point you take your lump sum, you could nevertheless take an income and use this monthly income to put into another personal pension. the advantage of this is that a personal pension is more tax efficient if you should die while it is still in place. You also have the potential to take another Tax Free Cash lump sum from funds in the personal pension.

If you die while the drawdown contract is in place, the fund will form part of your estate and will pass to your family. Depending on how your family use the fund it could attract a tax liability of 55%. With an Annuity, the fund is lost, and depending on the annuity options you selected your family may not receive any further benefit from it. This may be mitigated to a degree if an annuity with a guaranteed pension or partner’s pension is selected.

You can transfer the fund to a standard pension annuity at any point. This could be useful if you feel that you may qualify for an enhanced annuity in the future due to poor health. If you are in a guaranteed product you would lose the guarantee if you left the product before the term of the product had expired.

The following represent the key risks :

A pension fund is obviously intended to be used to provide money in your retirement. If you are now taking money from your pension fund before retirement you may seriously erode any income you could expect to receive in retirement. For this reason some drawdown providers will not accept drawdown business if the fund is below a certain amount.

The fund in your drawdown contract is subject to investment market fluctuations. If the funds you select do not perform you could find that the residual 75% has shrunk rather than grown. This again could have a negative impact on your retirement income. It should be remembered however, that if your existing pension is also invested in this way, then you are already exposed to this risk.

There is a possibility that if you deplete the fund too quickly you could run out of money in retirement. However we would remind you that you can still choose the more conventional annuity route at the time you retire if you wish. It would be prudent to take advice at that time.

If you were to die before you converted the drawdown into an annuity, then the fund would pass to your estate. If your partner wanted it as a lump sum it would be taxed at 55%.

Your existing pension may have some guarantees built in that you may lose if you transfer into a drawdown contract. You should check this, or authorise us to check on your behalf, before completing the switch.

Pension legislation keeps on changing. We have previously seen legislation introduced in 2006 and 2011. Both of these government bills had both positive and negative impacts on income drawdown. At any future point in time a government may again legislate on income drawdown and that legislation may impact negatively upon your plans.

Drawdown can be an excellent solution for many people, and we have many clients on our books who have used it to make a major impact on their lives.

It is not however an ideal solution for everybody and you must ensure you fully understand all the risks before taking an irreversible decision. If in any doubt whatsoever we strongly recommend you seek financial advice.