Now more than ever those aged 55 or over might be wondering whether to take a 25% tax-free lump sum out of their pension.
Many people are struggling to cover steep living costs, with high mortgage rates, fuel and food costs all making it difficult to make ends meet.
However, it’s important to remember that taking a chunk out of your pension cash will have a big impact on your future retirement income, so it isn’t something you should enter into lightly, or without seeking advice.
Here we outline some of the things you need to consider, and explain how to get advice on your pension. Bear in mind that the rules covered below apply to defined contribution pensions, where any contributions made are invested, and the amount you end up depends on how much has been paid in and how your investments have performed. You can find out more about defined benefit or final salary pensions and taking a tax-free lump sum from this type of scheme at the end of the article.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
Taking your tax-free cash – the rules
Under current rules, you can usually take a 25% tax-free lump sum from your defined contribution pension once you reach the age of 55. However, different pension schemes can have different rules, so check with your provider to see at what age you can start taking retirement benefits from your pension. Find out more in our article Should I take a tax-free lump sum from my pension?
Can I withdraw my pension?
The minimum age at which you can start taking benefits from your private or workplace pension is expected to increase to 57 in 2028 when the State Pension retirement age increases to 67 (there’s a 10-year gap between the minimum pension age and the State Pension age, so when the State Pension age rises, so does the minimum pension age.)
You don’t have to take the full 25% at once if you don’t want to. You might decide, for example, that you want to take less than this, or that you don’t want to take any money just yet as you’d rather leave your pension savings to benefit from investment growth for longer.
Consider the impact of taking a 25% tax-free lump sum from your pension
There are several things to consider if you’re thinking about taking a 25% tax-free lump sum from your pension:
What should I do with my tax-free pension lump sum?
You can spend your tax-free pension cash on whatever you want, with some people choosing to use the money to pay off a mortgage or clear other debts. However, if you don’t have an immediate need for the money, think carefully about whether you may be better off leaving it to grow tax-free – although of course as your money is invested there’s always a risk it could fall in value.
Depending on the level of interest you are paying on your debts, this might affect your decision on whether to focus on paying these off or leave the money invested in your pension. There are lots of different factors to consider, so you may want to seek professional financial advice to help you with your decision. For example, with best buy mortgage rates currently high, you’ll need to weigh up whether, over the long term, paying off the mortgage might be a better option for your money than the investments in your pension. Find out more in our guide What’s the best way to use my 25% pension tax-free cash?
You don’t have to take the 25% tax-free lump sum all at once
There are lots of different ways to take your pension, so you can take your tax-free cash in stages if you want to. For example, if you had a £20,000 pension, you may decide to take £3,000 of tax-free cash and then use £15,000 to buy an annuity, or income for life. You can find out more about how annuities work in our guide Annuities explained. You might then choose to leave the remaining £2,000 invested. Hopefully this would grow over time, boosting the value of the tax-free cash you’ve yet to take. At a later date, you might opt to take the remainder of your tax-free cash. Any withdrawals you make after this would be taxed as income.
Another option may be to take smaller regular amounts from your pension and opt for 25% of each of these payments to be tax free. So, for example, if you had a bigger pension pot and were to take £1,000 from it each month, £250 of this would be tax-free whilst the remaining £750 is taxable. Find out more in our guide How much tax will I pay when I withdraw my pension?
It could affect your entitlement to benefits
Your pension income will be taken into consideration when you’re assessed for means-tested benefits such as tax credits, Universal Credit and housing benefit, so think carefully about the impact that taking a lump sum could have on these and find out whether it will reduce your entitlement.
For example, if you take money out of your pension and as a result you end up with £16,000 or more in savings, you will not be entitled to any of these benefits.
If you have any savings or capital of between £6,000 and £16,000, the first £6,000 is ignored. The remainder is treated as if it provides you with a monthly income of £4.35 for each £250, or part of £250.
Example:
- You have £9,000 which you’ve taken out of your pension and put into a savings account
- The first £6,000 of it is ignored
- The remaining £3,000 is counted as giving you a monthly income of £52.20
- £3,000 ÷ £250 = 12
- 12 x £4.35 = £52.20
- £52.20 will be taken off your monthly Universal Credit payment
Only savings worth £6,000 (£10,000 if you are over State Pension age) or less will not affect your claim for means-tested benefits.
When can I retire?
The more you take out of your pension now, the less you’ll have to live on later, so it’s worth thinking about when you plan to retire and how taking your tax-free cash early could affect your retirement. Although a cash lump sum might be tempting, taking money out can have a compounding effect, as the smaller your pension pot at the start, the less you will benefit from any growth in the value of your investments too. Find out more in our guide When can I retire?
You’ll still be able to pay into your pension
If you just take your 25% tax-free lump sum cash, you can still pay in up to £60,000 a year into your pension and benefit from tax relief, known as your Annual Allowance.
However, as soon as you take out more than this, for example if you put your pension money into a drawdown scheme and you start to take income, or you’ve used it to buy an investment linked annuity where your income could go down, the maximum you’ll be able to pay into your pension each year will fall to £10,000. At this point, your Annual Allowance becomes known as the Money Purchase Annual Allowance. Learn more about this in our guide What is the Money Purchase Annual Allowance? If you buy a lifetime annuity that provides a guaranteed income you’ll normally be able to retain your £60,000 Annual Allowance.
Bear in mind that there are rules which prevent you from taking your 25% tax-free lump sum cash and paying it into another pension – if you do this there could be both tax consequences and extra charges to pay. This area of pension planning can be highly complex and will almost always depend on your own personal circumstances, so it’s worth speaking to a professional financial advisor who can help you navigate this.
Find out more about tax relief in our article How pension tax relief works and about pension allowances in our article How do pension allowances work?
Do you pay tax on your pension?
The amount of tax you’ll pay when taking money out of your pension depends on how much you want to withdraw, and on which tax bracket you fall into, but once you’ve taken your tax-free lump sum, the remainder will be treated as income for tax purposes.
It’s worth noting that there is a maximum tax-free lump sum you can take if you have a particularly large pension, and this is linked to the previous Lifetime Allowance which was scrapped in April 2024.
Put simply, you can take out up to 25% of your pension up to a maximum of £268,250 (25% of the old £1,073,100 Lifetime Allowance). If you have more than £1,073,000 in your pension, then the tax-free element you can take will be less than 25%. Learn more in our article How much tax-free cash can I take from my pension?
Options for the rest of your retirement pension savings
If you decide to take 25% lump sum cash out of your pension, you’ll then need to think about what to do with the rest of your retirement savings.
There are three main options:
Leave your pension invested in an income drawdown plan
This means the rest of your pension can continue to benefit from investment growth and you can take money from it in the form of an income, as and when you need it.
Use it to buy an annuity, or income for life
An annuity is essentially a contract with an insurance company – in return for handing over some or all of your pension, they will provide you with a guaranteed income for the rest of your life or for a set period. Annuity rates can vary widely, and therefore give you a very different retirement income from the same level of pension savings, depending on which provider you go to. This makes it essential to shop around for the best possible annuity deal and never just go with your existing pension provider.
Cash in your whole pension
If you’re considering cashing in your whole pension remember that only 25% will be tax-free and you’ll have to pay tax on the rest. This could push you up a tax bracket, so you’ll need to understand how much tax you’re likely to have to pay. You’ll also need to think carefully about how you’ll use the money to provide you with an income in retirement.
Getting advice on your pension
Pensions can be complicated, so if you’re not sure how to proceed, it’s worth seeking out professional advice. If you’re 50 or over and have a defined contribution pension, you can get free guidance on the options available to you from the Government’s Pension Wise service. However, if you want personal recommendations or advice about your specific circumstances, you’ll need to seek professional financial advice.
You can find a local financial advisor on VouchedFor or Unbiased, or for more information, check out our guides on How to find the right financial advisor for you or How to get advice on your pension.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
Can I take a 25% tax-free lump sum from my defined benefit or final salary pension?
If you have a final salary or defined benefit pension, you’ll receive a guaranteed income at retirement which is based on how many years you’ve belonged to the scheme and a proportion of your salary when you stop working. Some defined benefit schemes base your income on an average of your salary during the years you worked for your employer instead.
Withdrawing a lump sum from a final salary pension isn’t as straightforward as taking money out of a defined contribution pension, as this type of scheme isn’t as flexible. The amount you’ll be able to take as a tax-free lump sum from your defined benefit pension will usually depend on your particular scheme’s rules, which can vary widely. It’s also important to bear in mind that the more you take, the more guaranteed income you’ll forfeit when you retire.
For example, your scheme might offer you £10 in the form of a lump sum for every £1 of future pension you give up, whereas an alternative final salary scheme might offer £20 for every £1 of retirement income sacrificed. This is known as the ‘commutation rate’. The lower the commutation rate your scheme offers you, the less worthwhile it is taking a lump sum, so you’ll need to crunch your numbers carefully before you act, and seek professional advice on the impact it will have on your future retirement income. Find out more about defined benefit pensions and how they work in our guide What is a defined benefit pension?.
Is the State Pension taxable?
Your State Pension is taxable income, so you can’t take money from it tax-free. However, if the State Pension is your only income and falls below your Personal Allowance (£12,570 in the 2024/25 tax year) you usually won’t need to pay tax on it.
Beware pension scams
If anyone promises that they can release your tax-free pension cash earlier than the age of 55, then this is likely to be a scam and you should report it to Action Fraud on 0300 123 2040. If you have any concerns about an offer that has been made to you concerning your pension, contact the Government’s Pensions Advisory Service helpline on 0300 123 1047.
If you do take money out of your pension before the age of 55, then HMRC will consider this as an ‘unauthorised payment’ and you’ll be hit with a hefty 55% tax charge on the savings you’ve withdrawn, along with fees from your scheme provider for transferring your pension.
It is only possible to access your pension savings before the age of 55 if you are suffering from a serious illness. If this is the case, talk to your pension provider directly who will advise you about your pension’s rules – it’ll depend on their definition of ill health as to when you can access your money.
Beware anyone who cold calls you about your pension or who says that you can release money from it before the age of 55 as this is likely to be a scam. Find out more about pension fraud and scams in our article Don’t let scammers steal your retirement.
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