‘Are pension investment returns included in my tax-free lump sum?'

Write to Pensions Doctor with your pension problem: pensionsdoctor@telegraph.co.uk. Columns are published weekly.
Dear Charlene,
Please can you help me understand how the tax-free element of a Sipp (self-invested personal pension) works?
I have a Sipp from which I have already taken several withdrawals. My question relates to the basis of the 25pc tax-free cash part element.
Using hypothetical figures, if I started with an uncrystallised amount of £300,000, I understand I can withdraw up to 25pc from that tax-free. If I then crystallised some of my pension and withdrew £10,000, that leaves a balance of £290,000.
Being the beneficiary of a defined benefit pension, I didn't need to access any more of my Sipp funds again for a while, by which time the remaining £290,000 had grown to £330,000.
My question is – if I take some more tax-free cash in future, is the 25pc tax-free benefit based on the £290,000 figure, or on the new, higher value of £330,000? Any clarification would be much appreciated.
Regards,
– Jonathan
Dear Jonathan,
Although tax-free cash is often thought of as a one-off event, you don't have to take it all at once. You can take it in stages or chunks, as you've chosen to.
You're correct that most people can take up to 25pc of the value of their pension pots tax-free, subject to an overall lump sum allowance of £268,275.
The money and investments in pensions like Sipps that have not been accessed are known as 'uncrystallised funds'. So the £300,000 uncrystallised Sipp value in your hypothetical example could give you a tax-free lump sum (25pc) of up to £75,000 in one go, assuming you still have plenty of the lump sum allowance left.
If £75,000 was paid out, three times this amount, the remaining £225,000, would be moved into your chosen income option, such as drawdown. What is left in the pot is labelled as crystallised funds.
Without any new contributions being paid into the pot, there would be no uncrystallised funds, and no further tax-free cash available from it.
The same principle applies if we look at releasing smaller chunks of tax-free cash instead. When taking the tax-free lump sum of £10,000, you would crystallise a total of £40,000. The £10,000 tax-free lump sum is paid out and £30,000 is moved into crystallised funds. This can stay within the same Sipp, but the value is labelled and tracked separately.
The remaining £260,000, out of the initial £290,000, is still uncrystallised. The uncrystallised funds are what you can take more tax-free cash from in future. You can take an income from the crystallised, drawdown funds as and when you need to, but no more tax-free lump sums will be available from them.
The exact mechanics of this will depend on your pension provider, but investment growth (or loss) will usually be allocated in proportion across the uncrystallised and crystallised drawdown funds in your Sipp.
The individual investments and cash may not be earmarked specifically to either part. If you took any taxable income, the value is deducted from your drawdown funds, and the split adjusted accordingly.
The opposite would apply to any new contributions paid in – the value (and any tax relief) would boost the uncrystallised pot value.
Assuming no new money has been paid in or income taken out, the hypothetical Sipp now valued at £330,000 would be approximately split as £34,000 drawdown and £296,000 uncrystallised funds. Up to 25pc of the £296,000 uncrystallised funds could be taken as a tax-free lump sum at that point, or £74,000.
But as I mentioned earlier, you also need to have an eye on the lump sum allowance, and possibly the old lifetime allowance too.
If you accessed a pension before April 6 2024, you would have used a percentage of the lifetime allowance at the time. This includes when your defined benefit scheme started.
There's a standard calculation to work out how much of the new lump sum allowance you've got left. I've covered the calculations before, but the main point is that if you'd already used 100pc of your lifetime allowance, you'd have no remaining lump sum allowance left using the standard calculation.
If you have protection from the old lifetime allowance, the starting allowances in the calculation will be higher.
For any pensions accessed on or after April 6 2024, you should deduct the value of the tax-free lump sum you took from the remaining lump sum allowance each time.
Although the new lump sum allowance makes things simpler for people accessing their pensions now for the first time, people who have already taken money out or have started to be paid a pension before April 6 2024 still need to have a copy of the old rulebook to hand.
In my view, the best way to do this is to get regulated financial advice on your real personal circumstances before you make any further withdrawals. You'll have to pay for advice, but it could help you maximise your tax-free cash, put your mind at rest and help avoid any costly mistakes.
Wishing you a long and happy retirement,
– Charlene

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