Taking up to 25 per cent from your pension free of tax is a popular perk at retirement – so speculation that it could come under threat in the Budget is causing widespread dismay.
Savers typically use their lump sum to clear remaining mortgages and other debts, or splash out on home renovations, new cars and holidays.
Fears that Chancellor Rachel Reeves could cut the tax-free lump sum is leading to some savers rashly taking theirs while they can, experts warn. And while for some this could pay off – for example, if they planned to spend the money on a specific purpose – for others it could backfire, because they will miss out on vital investment growth.
Reeves did not tighten the rules in her Budget last year, but there was still an unprecedented 60 per cent surge in tax-free cash pulled from pensions, amounting to £18 billion.
Outflows are likely to have continued at a similar or even greater rate because of the Government’s plan to levy inheritance tax on pensions from April 2027, and worries about a future cap on tax-free cash.
So here’s what you need to know about tax-free lump sums, before you make an irreversible decision.
Fears that Chancellor Rachel Reeves could cut the tax-free lump sum is leading to some savers rashly taking theirs while they can, experts warn
How lump sums work
The minimum age you can start accessing private pensions is 55. You typically have the option of taking up to one quarter of your money as tax-free cash, while the remainder is used to secure a taxable income for the rest of your life.
You do not have to take your tax-free lump sum when you first access your pension, neither do you have to take it all at once.
But the rules depend on what kind of pension you have, which we explain below.
Taking a tax-free lump sum will not affect your income tax position.
The influx of funds will have no impact on your personal allowance, the threshold at which you start paying income tax, which is currently set at £12,570 a year and frozen until 2028.
It will not push you into a higher rate tax bracket either.
The 25 per cent tax free lump sum is currently capped at £268,275.
You may be entitled to more if you had taken out ‘fixed protection’ related to the old pension lifetime allowance, which stood at £1,073,100 when it was axed a few years ago.
Fixed protection is a complicated area, and if you have a large enough pension to have taken it out in the past it is best to get financial advice to avoid costly errors.
Many people nearing retirement may have a mix of modern ‘defined contribution’ pensions and traditional ‘defined benefit’ pensions, and the rules on tax-free cash differ for each type of scheme.
Invested pension pots
Defined contribution pensions take sums from both employers and employees and invest them to provide a pot of money at retirement.
Over-55s can take 25 per cent of their pension pot tax-free upfront, or opt to withdraw it gradually in chunks.
If you don’t withdraw the whole lump sum at once, you will have more tax-free cash available to take in the longer run.
You can take the lump sum and delay drawing any income. But you can’t do it the other way round, taking a taxable income without accessing any of the lump sum.
Former Pensions Minister Steve Webb, now a partner at pension consultants LCP, says you have four options:
- You can cash out the whole pension, with 25 per cent tax-free and incurring income tax on the rest;
- You can take the 25 per cent and use the rest to buy a guaranteed income for life – that is known as an annuity;
- You can take 25 per cent tax-free cash and leave the rest invested, making taxable withdrawals from then on;
- Or you can leave the whole lot invested, but take lump sums which are 25 per cent tax-free and 75 per cent taxed.
Mr Webb adds: ‘If you decide to cash out your whole pension pot, then it’s important that anything you don’t need doesn’t sit in a current account earning you very little.
‘Putting it in a tax-free Isa would mean you get investment growth on this part of your pension.’
Final salary pension
Final salary, or career average defined benefit pensions, provide a guaranteed income after retirement for the rest of your life.
Unless you work in the public sector, these have been mostly replaced by defined contribution pensions. But many people nearing retirement will have accrued benefits before the schemes were closed to new members.
If you have one, your options for a 25 per cent lump sum vary according to the generosity of the terms and conditions of your scheme, so you must check the details, including the minimum pension age.
The tax-free lump sum is available when you first start drawing a defined benefit pension, but not later on.
Final salary, or career average defined benefit pensions, provide a guaranteed income after retirement for the rest of your life
Mr Webb says: ‘In some cases, in a defined benefit pension scheme, the lump sum on offer is on a take-it-or-leave-it basis, and you have no option to vary the amount.
‘But in other schemes you can choose the combination of tax-free lump sum and regular scheme pension that you want to receive, subject to the overall tax-free limit of 25 per cent of the total value of your pension.’
Some defined benefit schemes require you to give up a relatively large amount of future pension for every pound of lump sum, so you should check carefully what you are forfeiting before deciding how much to take up front.
Multiple pensions
You do not have to take your 25 per cent from all your pensions at once. You can separate out your withdrawals, in terms of timing and the approach you take.
So with different defined contribution pots you might take the lump sum up front from one scheme, and with another opt to take the 25 per cent tax-free from each portion as you go.
If you have several defined benefit pensions, you could take more of, or all the tax-free cash, from the ones offering the most generous terms. From others you can go for the higher pension.
What are the pitfalls?
The minimum age you can start accessing private pensions will rise from 55 to 57 on April 6, 2028. This means people in their late 40s and early 50s need to start planning ahead.
Some will still be able to access their funds and tax-free lump sums, at age 55, depending on what their company pension scheme’s rules say.
So you should check – and be aware you might give up this right if you move a pension elsewhere.
Be wary of the annual allowance trap, too. When you start tapping into a defined contribution pension pot for any amount above your 25 per cent tax free lump sum, the amount you can put into your pension pot each year is restricted.
You will only be able to put away up to £10,000 a year and still qualify for valuable tax relief on the contributions.
This new and permanent limit is known in industry jargon as the ‘money purchase annual allowance’.
You therefore need to take care that you don’t take out more than the 25 per cent lump sum until you are absolutely ready – such as if you know there is no chance you will ever go back to work and rejoin a pension scheme.
The allowance is intended to deter ‘pension recycling’, which is another trap to avoid. This is where people put tax-free pension withdrawals back into their pots to benefit from tax relief again.
If HMRC decides that you have broken the rules, and done so intentionally, you could be hit with a charge of up to 55 per cent of the withdrawal.
The recycling rules are something to keep in mind if you are tempted to withdraw tax-free cash before the Budget then put it back if there are no changes after all, because the penalties are so stiff.
Inheritance tax
The Government announced in last autumn’s Budget that it will make pensions liable for inheritance tax like other assets such as property, savings and investments, starting from April 2027. It wants pensions to be used for their intended purpose of funding retirement, not as a vehicle to pass on wealth.
Some people are therefore likely to be unwinding existing plans to hand on pensions to their children, and instead some are taking tax-free lump sums now to gift them – because they become inheritance tax-free if you survive for another seven years.
Take it, or wait?
Money in your pension pots should be growing if properly invested. So unless you really need the cash now, it is probably better to leave the savings where they are for as long as you can.
When you do eventually draw a lump sum, it should then be larger because the fund has grown.
Andrew King, retirement specialist at wealth management firm Evelyn Partners, says: ‘We would encourage all pension savers to think twice before making major withdrawals from their pots, especially in anticipation of rumoured policy changes that might not materialise.
‘Unplanned or ill-conceived pension withdrawals can be subject to big tax charges, can remove funds from an advantageous tax environment, and could reduce your future standard of living in retirement, especially if they involve selling investments amid a market downturn.’
Steve Hitchiner, chairman of the Society of Pension Professionals tax group, warns: ‘Budget speculation is, by its very nature, speculative, and often proves to be largely inaccurate, and frequently causes problems.
‘Such speculation happens every year and it should never be used as the sole basis for making major financial decisions.
Steve Hitchiner, of the Society of Pension Professionals, warns: ‘Budget speculation often proves to be largely inaccurate’
‘Even if there are changes to the tax-free lump sum available, there would likely be transitional protections, too.’
If Reeves does meddle with the lump sum rules, it is most likely she would cut the maximum that can be withdrawn tax-free, rather than scrapping it altogether.
If she does cap it, we do not know what that number could be, but it would be a huge step to reduce it to below £100,000.
Pension experts warn against cashing in unless you have immediate plans for your pension tax-free cash.
But using it to pay off a mortgage or other debt can be financially advantageous, especially as you embark on retirement.
Or you may wish to spend your lump sum on a cherished retirement goal, such as doing up your home or taking a dream holiday.
Some savers who are planning to take their tax-free lump sum anyway could consider doing so ahead of any possible changes – especially if the amount exceeds £100,000. But think carefully before making any decision that may be irreversible, and don’t do anything that you would regret should the rules not change.
Where should I put it?
A stocks and shares Isa will allow your money to potentially carry on growing tax-free, if you invest wisely. Or you can find a high-interest cash Isa, as this would protect it from savings tax.
You currently have a £20,000 allowance every tax year. If you have a larger sum, transfer over money into your Isa up to the limit every year and make sure the remainder is not simply sitting in a current account or a low-paying savings account.
Put the money to use if you do not plan to spend it in the next few years, for example, in a high-interest savings account or a general investment account.
