A reader wants to know whether their investment withdrawals will be taxed fully or if 25 per cent can be taken tax free
In our weekly series, readers can email in with any question about retirement and pension saving to be answered by our expert, Tom Selby, director of public policy at investment platform AJ Bell. There is nothing he doesn’t know about pensions. If you have a question for him, email us at money@inews.co.uk.
Question: I have already taken my 25 per cent tax-free lump from my defined contribution pension and have a portfolio of investments set up to yield approximately £4,500 a year. To date, I have withdrawn nothing but my tax-free lump sum. I intend to only live off this dividend income, leaving the underlying capital untouched.
An important question for me is whether 100 per cent of these withdrawals will be taxable or will 25 per cent of them be tax-free? Equivalently, are all dividends paid into the self invested personal pension (SIPP) after taking the tax-free lump sum regarded as ‘crystallised’ or as ‘uncrystallised’?
I have had conflicting responses to this question and would be most grateful if you could give a definitive answer.
Answer: Defined contribution (DC) pensions are the most common in the UK, with a pot of money owned by you invested over the course of your life with the primary aim of delivering an income in retirement. People saving in DC schemes also often benefit from employer contributions in addition to upfront tax relief and tax-free investment growth. You can access your DC pension from the age of 55 (rising to age 57 in 2028).
When someone accesses a DC pension, they trigger an entitlement to up to 25 per cent of their fund tax-free. The rest of your pension will be taxed in the same way as income. The maximum pension tax-free cash most people can take in their lifetime is capped at £268,275, although some people may benefit from ‘protection’ which entitles them to a higher tax-free amount.
In order to access your tax-free cash, you need to ‘crystallise’ your pension pot – this just means choosing a retirement income route. For most people, this will be either drawdown (where you keep your fund invested and can take a flexible income whenever you want) or buying an annuity (a guaranteed income paid by an insurance company).
In your case, as you have opted for drawdown, your remaining fund can continue to grow tax-free. However, because your fund has been crystallised and you have taken the associated tax-free cash, any growth your pension enjoys in drawdown will not generate additional tax-free cash entitlement and your withdrawals will be subject to income tax.
However, additional pension contributions could generate additional tax-free cash entitlement, provided you have not used your ‘lump sum allowance’ (the maximum tax-free cash you can take over your lifetime). This would need to be a new contribution – a reinvested dividend as you have described would not generate any extra tax-free cash entitlement given it derived from an investment already held within the pension.
For anyone reading this who is considering accessing their tax-free cash, one option is to partially crystallise a chunk of your fund while leaving the rest untouched. This can allow you to get the tax-free cash you need (assuming there is something specific you want to spend it on) while leaving the rest of your fund, including the attached tax-free cash entitlement, invested with the potential to grow over the long-term.
Take, for example, someone who has a £100,000 pension but only needs £5,000 of tax-free cash. If they crystallised their entire fund, they would get £25,000 of tax-free cash, with the remaining £75,000 (including any investment growth it enjoys) taxed as income. If, however, they just chose to put £15,000 of their fund into drawdown, they could get their £5,000 tax-free cash and the remaining £80,000, including the 25 per cent associated tax-free cash entitlement, would have the opportunity to grow over the long-term.