Taking a pension tax-free cash lump sum

Written by Retirement Line

You can take a tax-free cash lump sum to spend as you wish

Whilst your pension fund exists to provide an income for your retirement, you have the option to access it however you wish from the age 55 (rising to 57 from April 2028). Normally, up to 25% of your overall pension fund can be taken entirely tax free; benefits from the rest are classed as taxable income. 

This is our guide to how the tax rules work for lump sums and the main options available to access your pension tax-free lump sum. 

If you are considering an annuity then do speak to our Annuity Specialists to fully understand your options for accessing your lump sum allowance. You may also wish to take advice from a financial adviser or tax specialist.

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The 25% tax-free lump sum pension rules

There are two main types of pension schemes, each with their own rules as to how you can access your money. These are defined contribution and defined benefit pension schemes.

Defined contribution Schemes

A defined contribution (DC) scheme is also known as a money purchase pension. Some workplace pensions and personal pensions such as self-invested personal pensions (SIPPs) come under this umbrella.

With these, you can usually take up to 25% of your total pension pot as tax-free cash once you reach 55 years old. You can access more money if you wish, though anything over your 25% tax-free allowance will be taxable. 

So, for example:

• If your pension fund is worth £80,000 and you choose to access £20,000 (25%), this will be tax-free.

• If you choose to take £40,000 from your fund (50%), perhaps to clear your mortgage, then the first £20,000 would be tax-free. You would have to pay tax on the additional £20,000 – the amount over your 25% allowance.

Defined benefit schemes

If you have a defined benefit (DB) pension – also known as a final salary – then the rules may be a little different for you. 

A DB pension scheme pays you based on how many years you’ve been a member of the employer’s scheme and how much your salary is when you leave or retire. 

How much tax-free allowance you have and how you can access your money will be determined by your own defined benefit scheme’s rules. You may find that you can access more than 25% of your pension tax-free. 

Remember – whichever scheme you have – the money you withdraw from your pension fund will reduce the amount you have left for your retirement. With a defined contribution scheme, if you have no real need for the money now, leaving it untouched in your fund could allow it to grow further until you decide to use it.

What is the maximum tax free lump sum from my pension?

The maximum you can normally take as a tax-free lump sum from your pension pot is the lesser of 25% of the fund value and £268,275. 

If the origin of this figure intrigues you, it’s because the upper limit of a person’s tax-free allowance is 25% of their ‘lifetime allowance’, the standard lifetime allowance is currently set by the government at £1,073,100.

Your maximum allowance may increase if you have lifetime allowance protection, though it depends on the lifetime allowance protection that you hold.

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Should I take my tax-free lump sum at 55?

You can currently access your defined contribution pension fund from age 55, though this is changing to 57 from 2028. Whether you should or not depends on your individual circumstances and your financial goals for retirement.

Despite being able to access your pension pot from this age, you may choose to delay taking your pension’s tax-free lump – or not take a lump sum at all. This would allow the money to stay in your pension scheme with the opportunity to grow until you need it.

Taking your tax-free allowance too early could mean you don’t have enough money left to meet your retirement income needs in the future. You will need to think about this carefully before making a decision.

Use our free annuity calculator to see how much income you could achieve with an annuity from your total pension fund. You can also enter the value of your pension fund LESS your tax-free lump sum to see the effect that will have on your annuity income.

Can I take my tax-free lump sum in stages?

You can take your pension tax-free cash as a lump sum, or in stages. 

If you choose to take your tax-free money from your pension fund then you have four main options:

• Arrange an annuity for regular guaranteed income: Access the tax free cash available from your pension pot  before you purchase your annuity with the remaining money. You may be able to take a bigger lump sum, but anything over 25% will usually be taxable. Also, with a fixed-term annuity, some providers let you take taxable lump sums during the term, in addition to agreed regular payments.

• Arrange a pension drawdown scheme: Access your available tax-free cash and the rest of the money is invested. This gives your money the opportunity to continue growing, though there are risks to consider with drawdown.

• Take your money in smaller amounts: 25% of each amount you withdraw could be taken tax free. The remaining 75% of each amount will be taxable if you exceed your personal allowance.

• Take your full pension fund in one go: If you do this, 25% of your pension fund will be paid to you tax-free. The remaining 75% will be taxable if you exceed your personal allowance for the tax year.

Here at Retirement Line we specialise in annuities that provide you with a guaranteed income in retirement. Speak to our friendly annuity specialists on 01733 973038 today to compare annuity types and get the best deal possible for you.

Can I take a tax free lump sum from more than one pension?

If you saved up your pension fund with multiple pension schemes over your career then you can take a tax-free lump sum from each of them if you wish. You can normally do this in two main ways:

• Access up to 25% of each fund tax-free.

• Consolidate your various pension pots into one large fund before accessing up to 25% of it as a tax-free lump sum. This may make your pension savings easier for you to manage in the future. Because of benefits that could be lost on transfer you should consider seeking professional independent financial advice prior to consolidation

Does the tax-free lump sum impact my personal allowance?

The good news is that any tax-free lump sum you take from your pension fund will not affect your personal allowance. After taking the tax-free money from your pension fund, you will still be able to enjoy the full personal allowance for that tax year entirely tax-free. For 2023/24 the personal allowance is £12,570. 

After accessing the 25% tax-free portion of your pension fund, you will pay income tax on the benefits from the remaining 75% of your pension fund.

Is a pension tax free lump sum classed as income?

No, you do not have to declare your 25% pension tax-free lump sum as income in your tax returns. The remaining 75% of your pension fund does however count as income when you access it.

Impact of tax-free lump sum on some state benefits

Your entitlement to some means-tested state benefits may be affected by a pension tax-free lump sum. This is because the money you receive can count when any means tests are carried out to check your eligibility. 

For example, means-tested state benefits such as Universal Credit or Pension Credit are given to people on the lowest incomes, with little or no savings set aside. If you receive a large cash lump sum from your pension fund then your entitlement could be impacted.

For this reason it’s very important to check if your entitlement to some state benefits could be affected by your pension tax-free lump sum before deciding anything.

Where can I keep my pension tax-free lump sum?

It is up to you where you put your pension tax-free lump sum. If you move it into your savings account or a cash ISA then do bear in mind that inflation could erode its value. 

You should also consider that the Financial Services Compensation scheme limit to protect cash deposits is currently £85,000 (or £170,000 for joint accounts) per firm.

It’s entirely your choice

Ultimately, how you access your tax-free money is your decision. Some people opt for the maximum tax-free cash, some want the maximum annuity income, others want a combination of the two. What is right for you depends on your personal circumstances and needs.

We hope you found this guide helpful in explaining how the tax rules work for pension commencement lump sums. If you want to talk to someone about annuities, annuity rates or how much tax free lump sum cash from your pension is possible, call us today. Our Annuity Specialists can provide information on your options for taking your lump sum allowance. 

You can speak to our friendly team today by calling 01733 973038 or request a free call back here.