Building up a pension to carry you through retirement is a very good thing, of course.
That being said, figuring out what to actually do with that money once it’s sitting in your account is the hard part. Here’s the thing, though: you don’t have to take it all at once. You don’t even have to touch it at all if you’d rather not. Pulling a chunk out now will shape your retirement income later, and that’s especially true if you happen to cash in at a moment when the stock market’s having a rough patch.
Some people know exactly what they want the money for. Ideally, that decision sits inside a proper retirement plan rather than being made on the spot. Others end up with a lump sum just sitting in the bank, not entirely sure what happens next, especially if they only withdrew it because of Budget rumours doing the rounds last year or this one. Take the cash without a plan, though, and a genuinely useful perk can quietly turn into a tax headache. Once that money’s out of your pension, it’s no longer growing tax-free, so protecting it from both tax and inflation becomes your job now, not your pension’s.
What the rules say about your tax-free pension allowance
Right now, you can generally take up to 25% of a defined contribution pension tax-free once you turn 55, rising to 57 in 2028. You’ll want to double-check your own scheme, however, since the exact age can change depending on where your pension sits. Got a final salary pension instead? The same idea applies, but the details will come down to your specific scheme’s rules.
One of the great things about a pension is being able to take a quarter of it without paying a penny of tax, right up to a cap of £268,275. If you’ve kept contributions going steadily over the years, that can add up to a serious amount of tax-free money by the time you’re ready to use it.
Whatever’s left after you take your tax-free slice usually gets moved into drawdown, used to buy an annuity, or simply taken as cash. Anything beyond that initial 25% gets taxed at your normal rate.
Why leaving it alone might be the smarter move
If you don’t actually need the money right now, think about whether you’d be better off just leaving that 25% where it is, still growing inside your pension. There’s no single right answer here, but it really is worth thinking properly about what you want the money to do, rather than pulling it out simply because you finally can. Leave it invested, and a couple of things work in your favour.
First, any growth happening inside your pension stays completely tax-free. Second, if your pot grows, your tax-free entitlement grows right along with it, though of course nothing about investment growth is guaranteed, and it can bounce around a fair bit in the short term. Just don’t lose sight of the fact that your pension has to carry you through the whole of retirement, so taking out a quarter and spending it without much thought could leave you stretched later on.
You’ll definitely want to consider this if your investments have dipped recently, since staying invested gives them room to recover and grow before you actually need the cash. Say you’ve got a pension worth around £200,000. You’d be entitled to take up to £50,000 tax-free from that. But if the pot instead grows by around 4.5% a year over the next decade, it could be worth roughly £325,779 before charges, meaning your tax-free entitlement grows too, to somewhere around £81,000. That’s the benefit of patience, a bigger pot, a bigger tax-free sum, and less income tax to pay on whatever you withdraw later. None of that’s guaranteed, mind, investments can fall just as easily as they rise.
What happens to it if you die
Here’s something else you should know: right now, pensions can pass to your loved ones completely free of inheritance tax and income tax if you die before turning 75. Die after 75, and your pension gets taxed as income once your beneficiaries withdraw it. That’s changing though, from April 2027, pensions will fall under inheritance tax for the first time ever.
If inheritance tax is likely to be a real issue once your pension’s counted as part of your estate, taking out whole of life cover can be a smart way to insure against that bill, so your family isn’t left covering it themselves. Set the policy up in trust, and the payout won’t even count as part of your estate for tax purposes. You pay in monthly, and when you die, your beneficiaries can use the payout to settle the inheritance tax bill straight away. These policies aren’t cheap, but if you’ve got a lump sum spare, setting some of it aside to cover years of premiums could genuinely pay off.
Should you use it to pay off your mortgage?
If you’re still carrying a mortgage or other debt, using your tax-free cash to clear it can feel like an obvious move, especially with interest rates having climbed the way they have. Fair enough, but you should think through the basics first. Generally speaking, clear any expensive debt first, then build up a proper emergency fund. Once those boxes are ticked, paying off the mortgage early, if that matters to you, or spending on something more discretionary like renovations or travel starts to make more sense. Just make sure none of that leaves you struggling later in retirement.
The interest rate on your debt is important as well, as it’ll shape whether clearing it beats leaving the money invested instead. There’s genuinely a lot to weigh up, so getting proper financial advice can help. Think about your mortgage rate, when your current deal ends, any other debts you’re carrying, and whether you’ve got other income to keep covering repayments once you retire or cut back your hours.
If your income’s likely to drop a lot, or bounce around unpredictably, clearing the mortgage might be the right call. Just watch out for early repayment charges if your deal still has them attached, these can run anywhere from 1% to 5% of what’s left owing, depending on how much time’s left on the deal. Sometimes it makes more sense to chip away at the balance gradually with smaller lump sums instead of clearing it all in one go.
Taking the cash in smaller chunks instead
You don’t have to take the full 25% in one lump either. Plenty of people take smaller amounts over time instead, topping up their income through drawdown or by taking the odd lump sum here and there. Doing it this way means more of your money stays invested and keeps growing.
Say you had a larger pot and took out £1,000 a month, £250 of that would be tax-free, with the remaining £750 taxed as income. Or you could use smaller sums just to bridge the gap until you reach State Pension age, currently 66 either way.
The simplest route is drawing what’s called an “uncrystallised pension lump sum” straight from your pot, no drawdown, no annuity involved. Every time you take one, the first 25% comes tax-free, and the rest is taxed as income. One thing to know is that doing it this way drops how much you can pay into your pension each year and still get tax relief on, down from the usual £60,000 to just £10,000, known as the Money Purchase Annual Allowance.
How much you take, and how, really comes down to your own circumstances. Just remember anything beyond that initial tax-free chunk gets taxed as income. And if you’re claiming means-tested benefits like tax credits, Universal Credit, or housing benefit, your pension withdrawals could affect what you’re entitled to, so think that through before you dip in.
Other things you could do with it
Thinking about spending your tax-free cash on something that isn’t strictly essential, a new car, a proper holiday? Nothing wrong with that, just weigh it up properly first. And remember, you don’t have to take the whole lump sum to do it, just take what you actually need.
Some people use theirs to fund a new business, or a career change later in life. Others choose to gift some, or all, of it to their children, and if you live for seven years after making that gift, no inheritance tax applies to it at all.
Avoid pulling the cash out with no real plan for it. There’s not much point taking money out of a tax-free pension just to let it sit in an ordinary savings account, over time, cash tends to lose value against the rising cost of living. Invest it outside your pension instead, and you could end up owing Capital Gains Tax on any growth, plus tax on dividends.
You should also keep some tucked away for later life, as care costs can be significant, and having a tax-free sum available might make a real difference. And once it’s spent, that’s it, there’s no putting it back.
Where to get solid advice
If you’re 50 or over, the government’s Pension Wise service offers free guidance on your options, no strings attached. If you want advice tailored specifically to your own situation, that’s when it’s worth speaking to a qualified financial adviser.
