Brits who withdraw tax-free cash from their pension without a plan risk triggering an unexpected tax charge, retirement experts have warned. Many people take their tax-free lump sum for a specific purpose, such as paying off a mortgage, funding renovations or travel.
“An example of this would be the speculation in the run up to the last Budget that the government was planning to restrict the amount of tax-free cash people could take,” she said.
“This led to people rushing to take what they could before the announcement was made. The announcement didn’t happen, leading to people having a large amount of cash with no real plan for what to do with it.”
She explained that if you have no use for the money and you reinvest it, this is where the issue could arise, because you may end up breaching pension recycling rules, which are governed closely by HMRC. If you breach the rules, it can trigger tax charges.
“Reinvesting the money back into the SIPP risks triggering anti-recycling rules aimed at preventing people from reinvesting tax-free cash into their SIPP to receive extra tax relief. If triggered this can result in a tax charge, so other options need to be considered.”
It only becomes an issue if you breach the rules. It would have to be proven to be pre-planned, and the amount would have to exceed £7,500, among other rules outlined by HMRC.
If an individual is caught breaking the recycling rules, the amount of the tax-free lump sum is regarded as an unauthorised payment and charges up to 40% may be applied to it.
If you are not sure what to do with a large lump sum, Ms Morrissey recommended withdrawing small portions at a time.
“It can be tempting to take your tax-free cash as one lump sum but if you don’t really need to do it then it might be better taking it in chunks over time instead.
“Phased drawdown enables you to transfer your pension into drawdown in stages and you can take up to 25% of each portion tax free as you do so. It can give you more flexibility in how and when you take your income.”