- Trevor, 60, is retiring with a £400,000 pension fund.
- He wants to use his tax-free cash to pay for a dream holiday and home improvements, which will cost £20,000.
- He has finished paying his mortgage and will need an income of £2,000 a month (£24,000 a year) after tax.
- He will initially fund this from his pension (through drawdown) until he qualifies for a full state pension at age 67, which will then part fund the income requirement.
Trevor takes his full tax free cash entitlement of £100,000. After paying for his holiday and home improvements, the remainder (£80,000) will be placed in a low interest savings account for emergencies:
This approach should allow Trevor to meet his income requirement until age 88, after which his pension fund would run out and he would become fully reliant on the state pension and other savings.
Trevor still has the remaining £80,000 of unused tax free cash (plus interest earned), which can be used to make up any future income shortfall or provide an inheritance to loved ones on death.
However, money held outside the pension will form part of Trevor’s estate - when added to his other assets, any amount exceeding the inheritance tax threshold will be subject to inheritance tax at 40 per cent.
Trevor only takes £20,000 of his tax-free cash entitlement to cover the holiday and home improvements. He then uses a combination of tax-free cash and drawdown income to provide his income needs in a tax efficient manner.
This approach allows Trevor to meet his income requirement indefinitely.
In fact, the drawdown fund is projected to start increasing in value again after age 78 - this will give Trevor scope to draw additional income to take into account rising costs (from inflation) and leave a significant legacy to family and friends when he dies.
There are many reasons why leaving your client's tax-free cash invested makes sense.
- They do not have a specific purpose for the money.
- They would leave their 25 per cent in a cash deposit account.
- Their estate is likely to have an inheritance tax liability.
IHT is levied at 40 per cent over £325,000, but pensions can often be passed on to beneficiaries tax free.
In some cases, it can make sense to spend non-pension assets in retirement first, leaving the pension fund and tax-free cash entitlement to grow in a tax privileged environment until such time as it is needed.
For instance, some retirees will have plans to downsize, which can free up significant equity from a property.
An additional £175,000 residence nil rate band is available for the main residence, with married couples able to inherit unused allowance from a spouse, which can increase the threshold from £325,000 to a maximum of £1m.
Taking the tax-free cash can make sense if your clients have a specific purpose for the money, such as:
- They have a mortgage that you want to pay off.
- They have debts that you want to pay off.
- They want to give money to children or grandchildren.
- Where their pension is at a level where it may breach the lifetime allowance in the future.
The LTA particularly can make any decision more complicated. Furthermore, since March’s Spring Budget, when chancellor Rishi Sunak froze most allowances and thresholds until April 2026, it is an area that has started to impact more and more people.
The allowances that were frozen include the lifetime allowance (frozen at £1,073,100), the inheritance tax ‘nil-rate band’ (frozen at £325,000) and ‘residence nil-rate band’ (frozen at £175,000).
In respect of the lifetime allowance, tax free cash is only available from the amount of a pension fund that sits within this limit.