You’ve taken your tax-free cash - now what?

Tens of thousands of over-55s have pulled money out of their pensions in the past year - many fearing tax increases in the Autumn Budget.  But now those changes have not transpired, some will be wondering what to do with the money.

Both last year and this year, it had been rumoured that the government would use the Budget to reduce the amount of tax-free cash you can take from your pension (currently 25% up to a maximum of £268,275).

• Read: Autumn Budget: how might the government change pensions?

However, in both cases, the rumours were proved wrong. Pension savers who withdrew money in anticipation of changes could find the decision could prove very costly over the long term.

So, what could the impact be and what options do retirees have to mitigate that impact? In this article, we’ll cover rules around cancellation rights and pension recycling.

What could the impact be?

Once you take money out of a pension, you lose the incredibly tax-efficient wrapper it provides. Unless you’re able to put the money into an ISA, any gains are likely to be taxed.

For example, if you had taken £100,000 of tax-free cash, put it in a General Investment Account, and it had grown to £180,000 by the time you need to access the money, you’d pay Capital Gains Tax (CGT) on that £80,000 gain. The rate will either be 18% if you’re a basic rate taxpayer or 24% if you’re a higher or additional rate taxpayer. That means a tax bill of either £14,400 or £19,200.

We’re assuming here you’ve already used up your CGT allowance for the year (which is £3,000). Those numbers could put a significant dent in your retirement pot.

The damage could be even greater if you take your tax-free lump sum and then leave it in cash. Left in a pension, the money had the potential to continue growing tax-free - whereas, left in cash outside an ISA or pension, any returns could quickly be eaten away by a combination of taxation and inflation.

This underscores the importance of having a plan for your tax-free cash before you take it.

• Get updates on markets, ISA funds, pension saving and much more

Can you cancel the decision?

Unfortunately, the decision to take your tax-free cash cannot be reversed or cancelled once processed. So, what could you do to protect the money?

Maximise your ISA allowance

If you have unused ISA allowance, you could put some of your tax-free cash there. Any gains made within an ISA are tax-free and withdrawals are tax-free too.

Each individual can put up to £20,000 per year into a stocks and shares ISA, so, between them, a couple could shelter up to £40,000 into ISAs per year. That means, over two tax years, you could contribute up to £80,000

• More on tax-efficient ways to make the most of your money and reach your goals

Pay the money back into a pension

It is possible to put tax-free cash back into a pension, but you must be very careful not to fall foul of government rules around “pension recycling”.

These rules are designed to stop people from taking tax-free cash and paying it straight back into a pension to get another round of tax relief.

If HM Revenue & Customs (HMRC) deems you guilty of pension recycling, it can impose a charge of up to 55% of the value of your tax-free cash.

To make that judgement, it uses five tests.

1. You received tax-free cash 
2. You make (or someone makes on your behalf) “significantly increased” pension contributions - this means your contributions increase by more than 30% compared to what might have been expected 
3. The contribution increase is linked to the tax-free lump sum and was pre-planned 
4. The recycling amount is more than £7,500 when added to any tax-free cash taken in the previous 12 months
5. The additional contributions are more than 30% of the tax-free cash sum received

If all the above are true, HMRC will consider that you have broken pension recycling rules.

However, in some instances, you can pay more into your pension without HMRC considering that pension recycling has taken place. For example:

1. You get a new, better-paid role and contribute a higher amount into the pension scheme 
2. You receive an inheritance and pay more into your pension
3. You increase your pension contributions because your business has become more profitable, but the percentage of your contributions is the same
4. You increase your contributions but not by more than 30% and not by more than 30% of the amount of tax-free cash you have received

If you are looking to put money back into a pension, it would be worth speaking to a qualified financial adviser to ensure you are not breaking any rules.

You also need to be careful not to inadvertently trigger the Money Purchase Annual Allowance (MPAA). If you took your tax-free cash and also took taxable income at the same time, this rule will be triggered.

Triggering the MPAA means the maximum amount you can pay into your pension from that point reduces from 100% of your earnings up to the annual allowance (currently £60,000 per year) to just £10,000 per year.

Even under the MPAA, you cannot contribute more than your earnings - although, if you have no earnings, you can still put up to £2,880 per year into a pension.

If you only take tax-free cash and do not put any money into drawdown, the MPAA should not be triggered.

• Read more helpful information on the money purchase annual allowance

Put the money into a spouse’s pension

You can take tax-free cash and put it into another person’s pension without it triggering pension recycling rules.

This is particularly helpful if your spouse or partner is a low earner with a smaller pension. But you can also pay into a child or grandchild’s pension - whether they are an adult or not. If they are an adult, you can pay into their workplace pension or Self-Invested Personal Pension (SIPP), and if they are under 18, you can pay into a Junior SIPP.

It’s important to keep the contribution within HMRC’s limits. If the person whose pension you are paying into is not earning any money, then the maximum amount you can contribute to their pension is £2,880 per tax year.

If they are earning more than £3,600, then the maximum that can go into their pension is defined by their pensions annual allowance - so up to 100% of their relevant UK earnings or £60,000 (whichever is lowest).

This maximum applies to all contributions, including what they themselves pay in, their employer contribution and tax relief. Higher earners (people earning more than £200,000 per year) are likely to face a tapered annual allowance.

Finally, remember you can carry forward unused tax allowances from the previous three tax years.

Gift the money

If the value of your estate is likely to exceed Inheritance Tax (IHT) nil-rate band, currently £325,000, and you don’t need your tax-free cash, then it may be worth gifting some of the money to your loved ones.

In general, the earlier you do so, the better. That’s because if you survive seven years after making a gift, it should be completely free of IHT.

Even if you don’t survive another seven years, the gift may still be IHT free so long as it fits within one of HMRC’s gifting allowances. Under these rules you can:

• Gift up to £3,000 per tax year under your annual allowance 
• Gift up to £5,000 to someone getting married (depending on their relationship to you) 
• Gift up to £250 to as many people as you like so long as you haven’t used any other allowance on them 
• Gift a potentially unlimited amount if it fits under the ‘gifting from regular income’ allowance
• Read more helpful information on Inheritance Tax

Pay off debt

It is not necessarily the most tax-efficient way of using the money, but putting tax-free cash towards paying off debts like a mortgage can be beneficial.

Often, people want to clear debts before they enter retirement to improve their cashflows and reduce risk. This is particularly helpful when mortgage rates are high.

The Government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944.

Fidelity’s Retirement Service also has a team of specialists who can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products although this will have a charge.

Got a burning question you want to ask? Why not drop us a line. Click here to ask your question.

• Read: Labour’s ‘no choice’ tax-raising Budget
• Read: Will salary sacrifice changes impact me?
• Read: Cash ISA cut: what does it mean for savers?

¹Thousands of savers with £250k pensions take cash over tax-free money and IHT fears | MoneyWeek

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). Eligibility to invest in an ISA and tax treatment depends on personal circumstances and all tax rules may change in the future. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.