If you’re 55 or over, you might be wondering whether now’s the right time to take a 25% tax-free lump sum out of your pension.
With living costs still squeezing budgets and some people facing redundancy or ill health, plenty are looking at ways to improve their financial position. Others are considering acting sooner because of planned inheritance tax changes, which from 2027 will bring pensions into scope for the first time. Whatever your reason, taking a chunk out of your pension now will affect your income later, so you need to think it through carefully rather than rushing the decision.
What the rules say about taking your tax-free cash
Under current rules, you can usually take a 25% tax-free lump sum from a defined contribution pension once you turn 55, rising to 57 from 2028. This applies to pensions where your contributions are invested, and what you end up with depends on how much has been paid in and how those investments have performed. Different schemes can set their own rules though, so check with your own provider to see exactly when you’re able to start taking benefits.
You don’t have to take the full 25% in one go. You might decide to take less, or leave your pension untouched for now so it can keep benefiting from investment growth for longer.
What to think about before taking a lump sum
You can spend a tax-free pension lump sum on whatever you like, whether that’s clearing a mortgage, paying off other debts, or passing some money on to family. With inheritance tax rules changing, some people are considering taking their lump sum earlier specifically to start the clock on gifting money to loved ones, since a gift given more than seven years before death generally falls outside the estate for inheritance tax purposes, with tapered relief potentially applying if the giver doesn’t survive the full seven years.
That said, if you don’t have a pressing reason to withdraw the money, you’ll need to weigh up whether you’d be better off leaving it invested and growing tax-free, bearing in mind that investments can fall in value as well as rise. If you’re weighing this up against paying off debt, the interest rate you’re currently paying matters too. With mortgage rates still relatively high, make sure you compare whether clearing a mortgage or leaving the money invested makes more financial sense over the long run, ideally with the help of a professional adviser.
You can take your tax-free cash in stages.
There’s more than one way to access your tax-free cash. You could, for example, take a smaller portion upfront and use the rest of your pot to buy an annuity, which pays you a guaranteed income for life. Alternatively, you could leave some of the pot invested and take the remaining tax-free cash later, once it’s had more time to grow. Any withdrawals beyond your tax-free entitlement would then be taxed as income.
Another option is to take smaller, regular withdrawals from your pension, with 25% of each individual payment tax-free and the rest taxed as income. This can work well for people who’d rather draw a steady amount over time than take one large lump sum upfront.
How a lump sum could affect means-tested benefits
If you receive benefits like tax credits, Universal Credit or housing benefit, you must understand how a pension lump sum could affect your entitlement, since your savings are taken into account during assessment. If a withdrawal pushes your total savings to £16,000 or more, you’ll lose entitlement to these benefits entirely.
If your savings sit between £6,000 and £16,000, the first £6,000 is ignored, but the remainder is treated as though it provides you with £4.35 of monthly income for every £250 you hold, or part of £250. For example, if you had £9,000 in savings from a pension withdrawal, the first £6,000 would be disregarded, leaving £3,000 to be assessed. That works out at 12 lots of £250, each counted as £4.35 a month, totalling £52.20 that would then be deducted from your monthly Universal Credit payment. Only total savings of £6,000 or less, or £10,000 if you’re over State Pension age, will leave your benefit entitlement completely unaffected.
Think carefully about your retirement timeline.
The more you take out of your pension now, the less you’ll have available to live on later, so think about when you actually plan to retire and how an early withdrawal might affect that. A lump sum can feel tempting, but taking money out early has a compounding effect too, since a smaller pot at the start means you’ll benefit less from any future investment growth as well.
You can still pay into your pension afterwards, within limits.
If you only take your 25% tax-free lump sum and leave the rest untouched, you can still pay up to £60,000 a year into your pension and receive tax relief, known as your annual allowance. However, the moment you start taking taxable income from your pension, for example through a flexible drawdown scheme or a variable annuity, that annual limit drops sharply to £10,000, becoming known as the money purchase annual allowance. If you instead buy a lifetime annuity that provides a guaranteed income, you’ll typically keep your full £60,000 allowance.
Know that you’re not permitted to take your tax-free lump sum and simply pay it straight into another pension, since doing so can trigger both tax consequences and additional charges. This area of planning gets complicated quickly and depends heavily on your personal circumstances, so professional advice is vital here.
How tax works once you start withdrawing
How much tax you pay when withdrawing from your pension depends on how much you take out and which tax band you fall into. Once your tax-free lump sum has been taken, anything further is treated as income for tax purposes.
There’s also a maximum tax-free lump sum available if you have a particularly large pension, linked to the old Lifetime Allowance, which was scrapped in April 2024. In practice, this means you can generally take up to 25% of your pension, capped at £268,250. If your pension is worth more than roughly £1.07 million, the tax-free proportion you’re able to take will be less than 25%.
What to do with the rest of your pension savings
Once you’ve decided on your tax-free lump sum, you’ll need to think about what happens to the rest of your pot. Broadly, there are three main routes. You could leave it invested in an income drawdown plan, allowing it to continue growing while you draw an income from it as needed.
Alternatively, you could use it to buy an annuity, essentially a contract with an insurer that provides a guaranteed income for life, or for a fixed period. Annuity rates vary considerably between providers, so shop around properly rather than automatically going with your existing pension provider. The third option is cashing in your entire pension at once, though it’s important to remember that only 25% of this will be tax-free, with the rest taxed as income, potentially pushing you into a higher tax bracket depending on the amount involved.
Getting help making the right decision
Pensions can get complicated quickly, so if you’re unsure how to proceed, seeking qualified guidance is a sensible step. Anyone aged 50 or over with a defined contribution pension can access free, impartial guidance through the government’s Pension Wise service. If you want a personal recommendation tailored to your specific circumstances though, you’ll need to speak to a regulated financial adviser instead.
What happens if you have a final salary pension instead
If you have a defined benefit or final salary pension, your income in retirement is based on how many years you were part of the scheme and a proportion of your salary, sometimes calculated as an average across your working years with that employer. Taking a lump sum from this type of pension works quite differently to a defined contribution scheme, since these arrangements are far less flexible.
How much tax-free cash you can take will depend entirely on your specific scheme’s rules, and the more you take, the more guaranteed retirement income you’ll give up in return. This trade-off is known as the commutation rate, and it can vary significantly between schemes. Some schemes might offer £10 in lump sum cash for every £1 of future pension you sacrifice, while others might offer double that. A lower commutation rate generally makes taking a lump sum less worthwhile, so it’s essential to run the numbers carefully, ideally with professional advice, before making a decision.
Is your State Pension taxed the same way?
Your State Pension counts as taxable income, so there’s no tax-free element to it in the way there is with a private or workplace pension. That said, if the State Pension is your only source of income and it falls below your Personal Allowance, currently £12,570, you generally won’t need to pay any tax on it at all.
Watch out for pension scams.
If anyone contacts you promising early access to your tax-free pension cash before age 55, this is almost certainly a scam and should be reported to Action Fraud. If you’re ever unsure about an offer relating to your pension, the government’s Pensions Advisory Service can offer free, independent guidance.
If you do withdraw money from your pension before turning 55, HMRC treats this as an unauthorised payment, triggering a hefty 55% tax charge on whatever you’ve withdrawn, on top of any fees your provider charges for transferring funds. The only exception is if you’re seriously ill, in which case your provider can advise on accessing your pension early based on their own definition of ill health. Be particularly wary of anyone who cold calls you about your pension or claims you can access it before 55, since this is one of the clearest warning signs of a scam.
