Getting your hands on a quarter of your pension cash may feel like a long-awaited dream for many – but taking it in the wrong way could cost you later in retirement.
When you reach 55, you can withdraw up to 25% of your pension savings as a lump sum without paying any tax.
But experts warn you could lose out on thousands of pounds if you rush in and grab your allowance without following the rules.
Here, we explain everything you need to know about taking the tax-free cash and how to avoid any financial penalties.
When you get income from pensions – both the state pension and private pensions – you normally have to pay income tax on anything over the personal allowance, which is currently £12,570 per year.
But a special privilege of pensions is you can take some of the money free of income tax, which is a key reason for saving into pensions in the first place.
If you have private pensions or workplace pensions – as most employed people now do – you can take up to 25% of the total value of all your pension pots as a tax-free lump sum.
You are currently allowed to access this money from age 55 onwards, but this will rise to 57 in April 2028.
For many savers, their tax-free lump sum would give them a way to pay off other significant debts or clear their mortgage.
Other typical ways of spending the cash include buying a holiday home, or gifting the money to children or grandchildren.
And research by financial firm Standard Life last year found one in five pensioners planned to spend some of the cash on home renovations.
However, Jason Hollands, managing director of wealth manager Evelyn Partners, said that while clearing mortgages and debts when you are in your mid-fifties is “very wise”, people should otherwise “think carefully” about how else they plan to use the money.
“Giving a chunk of your pension away or spending it on ‘nice to have’ things might leave you short of the financial resources you need to have a secure retirement later on,” he said.
“No one should want to put themselves in a position where they run out of money halfway through retirement.”
And if you don’t really need to take the money urgently, you could lose out long term compared to if you left it invested in your pension.
Tom Selby, director of public policy at wealth manager AJ Bell, explained: “If you take your tax-free cash out and simply shove it in a bank account, there is a danger over the long-term its value will be eroded away by inflation.
“By contrast, if you keep the money in your pension for longer, it has the opportunity to grow tax-free – meaning you could get more tax-free cash in the future (although investments can, of course, go down as well as up).”
Here's an example of why you might not take your tax-free cash:
You have a £100,000 pension pot at age 55. You put £75,000 into drawdown – a way of getting pension income when you retire while allowing your pension fund to keep on growing – and you are then able to access £25,000 tax-free cash.
However, your remaining £75,000 won’t generate any more tax-free cash – even if it grows.
On the other hand, if you left the full fund invested for a further 10 years and enjoyed a modest growth rate of 4% a year, after charges, you could have a fund worth around £150,000 – with around £37,500 available tax-free.
The other thing to consider, says Mr Selby, is inheritance tax (IHT).
While money held in a pension can be passed on free of IHT – and potentially income tax-free if you die before age 75 – money held outside your pension could form part of your estate and be taxed at 40%.
“This is one of the reasons it’s important to have a plan for your tax-free cash before taking it,” Mr Selby said.
What people do when they access their pot
| % | Average value | |
| Buy an annuity | 8% | £ 71,695.34 |
| Go into drawdown | 30% | £ 128,027.38 |
| Withdraw it all | 56% | £ 12,491.64 |
You also don’t have to take your 25% tax-free cash in one go.
In fact, there are ways to take it that can leave you thousands of pounds better off.
When it comes to defined contribution pensions – the type most of us have now – there is a new option to take your tax-free pension in chunks.
LCP’s Steve Webb explained: “In this case, you tell your pension provider this is what you want to do and they set up your account so each withdrawal is 25% tax free and 75% is taxable.
“Assuming the money you haven’t taken yet continues to grow, you could end up getting more tax-free cash in total.”
AJ Bell’s Tom Selby gave an example of someone with a £100,000 pension who needs £5,000 of tax-free cash.
“Rather than taking their entire £25,000 entitlement, they could just commit £15,000 to drawdown (cash taken as income), and take the £5,000 tax-free cash they need,” he explained.
“The benefit of this is that the tax-free cash attached to the remaining £80,000 that hasn’t gone into drawdown could continue to grow tax-free over time – and it wouldn’t be part of your estate for IHT purposes.”
Analysis by pension company PensionBee found taking small amounts from a pension pot regularly would give savers more money long-term compared to withdrawing large one-off amounts.
Over a 20-year period, a saver who gradually withdraws from a £50,000 pension pot would be left with close to £20,000 more in spending power, compared to someone who withdraws the same amount through large one-off withdrawals every 10 years, PensionBee found.
The effects arise due to the compounding power of pension returns over time.
Compound returns are where you earn money on a sum, and as the sum grows, you in turn earn more money on it. This creates a “snowballing effect” that gets bigger and bigger over time.
It’s important to remember that if you take a lump sum at the start of your retirement, then that’s money you don’t have to support you through the rest of your life.
“For example, if you need an income for life – which you can get by buying an annuity – you will obviously get a bigger annuity if you haven’t taken 25% out first thing,” explained Steve Webb, partner at pension consultants LCP.
WE round-up the main types of pension and how they differ:
Likewise, if you have a defined benefit pension, where you get a guaranteed income for life, then often you have to give up some regular pension income in exchange for the lump sum.
In some schemes – often public sector schemes such as the NHS or Teacher’s Pensions – you give up a lot of regular pension to get a lump sum.
“If you are in good health and have a long retirement you may do better to have the higher regular pension,” Webb said.
Finally, if you do decide to take out your 25% tax-free lump sum, one of the issues to think about is what you do with the remaining money.
Remember, you don’t need to take all of your pension in full to access your tax-free cash, but many people do – and it costs them a lot.
Watchdog the Financial Conduct Authority (FCA) has found a huge 35% of people who cashed out their pension in full put the balance into a current account or cash account, making hardly any interest.
“It’s generally a bad idea to leave the rest of the money in a current account or cash ISA when it could have been inside a pension and still growing,” says LCP’s Steve Webb.
It makes sense to keep the money invested and growing, which will provide you with a bigger pot to support you in retirement.
After all, said Evelyn Partners’ Jason Hollands, “pensions grow tax-free, so withdrawing the cash simply to stuff it in a savings account where any interest is likely to be subject to tax, really doesn’t make sense, and will probably lead to lower returns too”.
It is important to consider the tax implications of what you might use your tax-free money for.
For example, some people choose to take their tax-free cash to buy a rental property as they are attracted to the idea of owning something physical.
But Jason Hollands from wealth manager Evelyn Partners says this is often a costly mistake.
“While pension growth is tax-free, property investing involves lots of costs and is not tax-friendly,” he points out.
“You will have stamp duty to pay on a purchase, rental income will be taxable and if a second property is sold later there could be capital gains tax on any gains,” he says.
Plus, when you die, the property – alongside other assets you own – could be subject to IHT unlike a pension under the current rules.
