Drawing Tax-Free Cash from a UK Pension: Benefits, Drawbacks and the 2024 Autumn Budget

With the 2024 Autumn Budget looming, many financial planners and their clients are concerned about the potential future of pension benefits, especially around tax-free cash. Chancellor Rachel Reeves has signalled that the upcoming budget will involve difficult fiscal measures, leading to speculation about potential changes to pensions. For our clients—especially non-UK residents—it is vital to understand the benefits and drawbacks of drawing tax-free cash from a UK pension before the budget and to seek professional advice before making any decisions.

 

The 2024 Autumn Budget: What to Expect

Chancellor Rachel Reeves has warned that the upcoming 2024 Autumn Budget will involve tough decisions aimed at stabilising the UK’s finances. While there is no confirmed plan to alter the tax-free pension lump sum, pensions have been a target for reform in previous budgets, especially given the government’s need to raise revenue.

This uncertainty is leading many clients to consider accessing their tax-free cash now, while the current rules remain in place. For non-UK residents, however, the key issue is not only what happens in the UK, but also how their local tax authorities will treat the withdrawal. A lump sum that is tax-free under UK rules may not retain that status abroad, which is why it’s essential for non-UK resident clients to seek advice before taking action.

 

What is Tax free cash from a UK pension?

In the UK, pension holders can withdraw up to 25% of their pension as a tax-free lump sum (subject to the Lump Sum Allowance of £268,275 and any pension protection that may be in place) once they reach 55 (this will rise to 57 from 2028). This tax-free entitlement is often seen as a significant benefit, offering liquidity without immediate tax liability on the remaining pension, which can be used for drawdown or left invested for future growth.

However, for non-UK residents, the situation is more complicated. Many of our clients live outside the UK, and while the UK government treats this the lump sum as tax-free, the country of residence may not. Tax laws differ across jurisdictions, and it is essential that non-UK resident clients obtain tax advice in their local country before accessing any lump sum from their UK pension. Failure to do so could result in unexpected tax liabilities.

As the 2024 Autumn Budget approaches, it’s important to evaluate the potential benefits of drawing tax-free cash now and the possible consequences of waiting. Let’s explore these factors in more detail.

 

Benefits of Drawing Tax-Free Cash Before the Autumn Budget

1. Protecting Against Potential Reforms

One of the key reasons clients may want to consider taking tax-free cash before the Autumn Budget is the possibility of changes to pension rules. Chancellor Rachel Reeves has indicated that this will be a “painful” budget, raising concerns that pension benefits may be targeted as part of efforts to increase revenue.

Although there has been no direct confirmation that the tax-free lump sum will be affected, speculation in the press suggests that future restrictions or reductions could be on the table. By taking tax-free cash before any such reforms, clients can lock in their entitlement under the current rules.

For non-UK residents, securing the lump sum under the UK’s tax rules could be particularly appealing, but it’s vital to remember that this tax-free treatment may not apply in their country of residence. Cross-border tax advice is essential to avoid any unforeseen tax liabilities.

 

Drawbacks of Drawing Tax-Free Cash Before the Autumn Budget

Given that once you draw the tax-free cash you can’t put it back into the pension, here are some drawbacks to consider:

1. Loss of Future Investment Growth

A significant drawback of drawing tax-free cash early is the potential loss of future investment growth within the pension. Pensions are designed to grow tax-free, providing long-term investment returns that can build up over time. By withdrawing a portion of the pension as a lump sum, clients reduce the size of their invested pension pot, potentially missing out on future gains from compounded growth.

For instance, withdrawing £100,000 today means that amount is no longer invested and benefiting from tax-free growth. Over a decade or more, the growth on that £100,000 could have been significant, depending on market performance. While withdrawing tax-free cash may provide immediate liquidity, it could reduce overall retirement savings in the long run.

 

2. Tax Implications for Non-UK Residents

For non-UK resident clients, one of the most important considerations when accessing tax-free cash is the potential tax treatment in their country of residence. While the UK allows the lump sum to be drawn tax-free, many other countries do not offer the same treatment. Depending on local tax laws, clients could be subject to income tax or other levies on the cash withdrawn from their UK pension.

As a result, non-UK residents should seek local tax advice before withdrawing any lump sum from their pension to ensure they understand the tax consequences. A lump sum that is tax-free in the UK may create a significant tax liability abroad, eroding the perceived benefit of accessing the funds early. This can be a costly oversight if not carefully considered.

 

3. Growth Within a Pension is Tax-Free

Another key drawback is that the growth of funds within a pension is tax-free, providing an attractive environment for long-term investment. Once the tax-free cash is withdrawn, however, the money loses this tax-advantaged status. Clients who choose to reinvest the lump sum elsewhere may find that they are unable to place the full amount into another tax-efficient vehicle.

For example, reinvesting the cash into ISAs (which also offer tax-free growth) is limited by the ISA contribution cap, currently set at £20,000 per year (as of 2024). This means that only a fraction of the lump sum (dependent on the amount received) can be reinvested in a tax-free wrapper, while the remainder may need to be placed in taxable accounts, where future investment growth could be subject to capital gains or income tax. This limitation makes it unlikely that clients can replicate the tax-free growth benefits they enjoyed within the pension.

 

4. Impact on Future Retirement Income

Taking a large portion of tax-free cash now reduces the amount left in the pension pot to generate income in retirement. If a client plans to use their pension to provide a sustainable income through drawdown or an annuity, withdrawing a significant lump sum early may limit their future income options. A smaller pension pot can lead to lower sustainable withdrawal rates, increasing the risk of depleting retirement funds too quickly.

This can be particularly concerning for clients with longer life expectancies or those who anticipate needing a steady income stream over several decades. By taking tax-free cash now, clients may compromise their financial security in the later stages of retirement.

 

5. Inheritance Tax (IHT) Considerations

A frequently overlooked drawback of withdrawing tax-free cash from a pension is its impact on inheritance tax (IHT) planning. Pensions typically fall outside an individual’s estate for IHT purposes, allowing them to be passed on to beneficiaries without incurring IHT. However, once tax-free cash is withdrawn, it becomes part of the individual’s estate. If the estate exceeds the IHT threshold—currently £325,000 for individuals, or £650,000 for married couples—any amount above this threshold (assuming the Residence Nil Rate Band is not utilised) could be subject to a 40% tax upon death.

For example, if a client withdraws £100,000 in tax-free cash and retains it in savings or taxable assets, their estate’s value will increase by £100,000, potentially pushing it over the IHT threshold. As a result, their beneficiaries could face a significant tax bill, reducing the amount of wealth passed on. Clients should carefully consider the IHT implications of withdrawing tax-free cash, particularly if legacy planning is a key part of their financial strategy.

 

6. Inflation Erosion of Cash

Another potential issue with taking tax-free cash early is the risk of inflation eroding the value of the withdrawn amount. If the cash is not needed immediately and is held in a low-interest savings account, inflation could reduce its purchasing power over time. By contrast, keeping funds invested in a pension, where they can grow tax-free, offers some protection against inflation, as the investment can potentially outpace the rising cost of living.

 

Conclusion

For those affected—particularly those living outside the UK—drawing tax-free cash from a UK pension before the 2024 Autumn Budget requires careful consideration. While securing the current 25% tax-free entitlement may seem appealing in light of possible pension reforms, there are significant drawbacks to consider, including the loss of tax-free growth, potential tax liabilities in the client’s country of residence, and inheritance tax implications.

Given the complexities of international tax rules and the uncertainty surrounding future pension legislation, if you are concerned about your pension, we encourage you to contact us to discuss your needs. A well-considered strategy, tailored to your individual circumstances, is the best way to ensure long-term financial security in retirement.

 

Philip Teague

Cross Border Financial Planning

 

 

A pension is a long-term investment not normally accessible until age 55 (57 from April 2028 unless the plan has a protected pension age). The value of your investments (and any income from them) can down as well as up which would have an impact on the level of pension benefits available. Your penion income could also be affected by the interest rates at the time you take your benefits.

Please feel free to contact us to find out more.

The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change. You should seek advice to understand your options at retirement.

The Financial Conduct Authority do not regulate tax planning. Cross Border Financial Planning are not tax advisers and we do not offer tax advice.