Tax-free cash: will I be a higher rate taxpayer?

Q: I have a final salary pension that will pay approx £70k per year. If I retire this March and take my 25% tax free sum I will still be a higher-rate taxpayer. If I wish to spend some of the funds taken tax-free, in order to have expensive holidays in the early years of retirement, will I pay high rate tax on that money (as it will be like “income” that year over and above my pension)? In other words, do I end up paying 40% tax on it eventually anyway? 

A: If you take 25% of your pension fund as a tax-free lump sum, this money will not be subject to income tax, regardless of when you spend it. You can keep it in a bank account or similar and draw on it as needed. The money you take out isn’t counted as ‘income’ and won’t need to be included on a self-assessment form. Bear in mind that if your pension is very valuable, the total amount of tax free cash you can access is usually capped. However, this doesn’t mean there aren’t other tax considerations to take into account.  

If this is a significant sum and you don’t plan to spend it all at once, you need to consider where to deposit it. The most tax-efficient option is to put it in an ISA, where any interest earned or investment gains are tax-free. You can contribute up to £20,000 to an ISA each tax year. If your lump sum exceeds this, or you’ve already used your ISA allowance, you’ll need to look at other options. 

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If you’re planning to spend this money within the next five years or so, cash deposits are probably the most suitable option. As a higher-rate taxpayer, you can receive up to £500 of interest tax-free annually, but any interest above this threshold will be taxed at 40% — and you will need to include details on these interest payments on your self-assessment tax return. Basic-rate taxpayers can receive up to £1,000 a year in interest payments before savings tax is applied.  

If you are married or in a civil partnership there may be opportunities to reduce this tax bill. Robert Salter, tax technical director at accountancy firm Blick Rothenberg says a pension saver can deposit any unused part of their tax-free lump sum in an account in their spouse’s name, to ensure all relevant allowances and reliefs are being utilised. This could be in an ISA in the spouse’s name or a savings account. This is particularly relevant if your spouse is a basic-rate taxpayer they can earn up to £1,000 in interest a year before interest is taxed.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). Tax treatment depends on individual circumstances and all tax rules may change in the future. 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.