Tax-efficient ways to cash in a lump sum

From a nicer car to a lavish holiday all the way through to upsizing your home, investing can help you afford luxuries that you would otherwise have been unable to. But when the time comes to cash in a lump sum from your portfolio to fund a big expense, you need to think carefully about how to do it.

The process requires picking the assets it makes most sense to sell, avoiding crystallising losses at the wrong time, and keeping tax efficiency at the front of your mind when deciding on the account from which you will draw the cash.

What to sell and when

Deciding what to sell can be tricky and requires a certain discipline. Rob Morgan, chief investment analyst at Charles Stanley, explains: “Depending on how a person thinks about investments, there can be an in-built bias in our brains to either drawing from outperformers or from laggards – so try to take an objective view. The default position would be to top slice across all your holdings to retain the original shape and composition of the portfolio.”

In practice, though, this could be a good time to review your portfolio. Your risk appetite and goals might have changed since you last set your strategy, so you could opt for a more or less aggressive approach and decide what to sell accordingly. “This might be common upon retirement, for instance, when a house move or renovation coincides with a change of investment objectives from growth to income,” says Morgan. 
 
Even if you want to keep the same asset allocation, you should check whether your portfolio still reflects it. Depending on how your assets perform, they need to be rebalanced periodically – a bull run might lead to a higher exposure to equities than what you originally wanted, for example, or you might find yourself with more exposure to US tech stocks than you are comfortable with. “If the portfolio has become a bit imbalanced, this is a good opportunity to withdraw more from the areas that have become larger and gone on to dominate too much,” says Morgan.

It is also a good time to consider whether you still have conviction in all your holdings. This consideration may differ depending on whether you invest in funds or single stocks – for example, funds can underperform over certain periods if their investment style is out of favour, but you might still want the diversification these offerings bring. “All active funds will undergo spells of underperformance, so a period of relatively poor returns is not necessarily a reason to sell, especially over a short timeframe. However, it can be a prompt to consider whether there are any preferable alternatives,” says Morgan. 

Planning the transaction in advance can be helpful. Cashing in your investments early protects you from the risk of a market crash hitting just when you need the money, which would force you to crystallise losses. As Nick Winter, financial planner at Quilter, puts it, while “waiting for the perfect time to sell up investments can be a fool’s errand”, you naturally want to avoid selling during a downturn. If you sell up early, you can keep the sum in cash or short-term government bonds in the meantime, so that it earns some return but with a much lower level of risk.

You also face the dilemma of whether to take the sum all in one go or sell gradually to try to smooth out the volatility – a little like when you have a lump sum to invest and need to choose between buying in straight away or drip-feeding it into the market. As is the case in that scenario, the second option can feel less scary, but doesn’t always give the best results. It all depends on what the markets do in the meantime. 

Do keep an eye on dealing fees. Depending on your platform and how big a sum you are cashing in, these can eat away at your gains, especially if you opt for multiple transactions. Hargreaves Lansdown has one of the highest dealing fees among the mainstream platforms at £11.95 per deal (albeit with discounts if you placed 10 deals or more the previous month).

Tax efficiency

From a financial planning perspective, one of the biggest mistakes you can make is taking a large sum from a taxable account, such as a pension, in cases where doing so pushes you into a higher income tax bracket, says Winter. 

For example, say you receive £50,000 a year from a final-salary pension, which forms the bulk of your income. You want to take an extra £30,000 from your investments because your home is in need of some serious renovations, and you can choose between taking it from your £300,000 personal pension or from your £300,000 individual savings account (Isa).

If you’ve already taken the tax-free lump sum, anything you take from your pension pot will be taxed as income. Because you are already receiving a £50,000 pension, almost everything you withdraw on top of it from your pension pot will be taxed at the 40 per cent rate of income tax. To get the £30,000 you need, you would need to withdraw in the region of £50,000. Meanwhile, Isa withdrawals are tax-free.

“It is always sensible to start with extracting money from your Isas,” says Winter, although he notes that this is not a hard-and-fast rule and can depend on a variety of circumstances such as investment performance.

“Another important consideration is that you will trigger the money purchase annual allowance (MPAA) if income is taken from the pension flexibly,” Winter adds. “This will reduce the annual allowance [the amount you can save into your pensions] from £60,000 to £10,000 per year. The run-up to retirement is a time when people often make significant contributions to their pensions so this can impact that ability.”

If you still have the pension tax-free lump sum available, that is a tax-efficient option. You do not need to withdraw it all in one go and it doesn’t necessarily trigger the MPAA. “But remember that your pension pot is designed to support you during your retirement, which is a time when you may not have any other forms of income,” Winter says.  And if you think you might have an inheritance tax (IHT) issue in the future, it’s best to spend your pension last because it will not form part of your estate when you die.

If you don’t have much in your Isa, cashing in some money from a general investment account might also be an option. Gains are subject to capital gains tax (CGT), but for higher-rate taxpayers the rate applied is 20 per cent, lower than the income tax threshold, and the first £3,000 of gains are tax-free thanks to the CGT allowance. If you have to crystallise investment losses in a GIA, they can be declared to HMRC and used to offset against future gains.