Pension tax-free lump sum warning as early withdrawal could cost savers £63,000

Over 55s could leave themselves £63,000 worse off by taking their 25% pension tax-free lump sum early rather than leaving it invested, new research suggests.

Someone aged 55 who decided to take out their full lump sum allowance from a pension pot worth £500,000 and add it into a cash savings account paying 4% could be £63,169 worse off by the age of 65, according to AJ Bell.

The analysis found even if they took out their full lump sum and drip-fed it into a cash ISA they could still miss out on £45,029 in returns. Investing it in a stocks and shares ISA, where returns are expected to be higher, could cushion some of the blow, but they could nevertheless lose out on £18,358, compared to leaving the money to grow in their pension pot.

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The warning comes amid speculation the chancellor Rachel Reeves could reduce the amount of tax-free cash pensioners can take at retirement, prompting many over 55s to make early withdrawals from their pots.

Tom Selby, director of public policy at AJ Bell, said rumours of changes to pension rules risked panicking people into making rash decisions.

“The potential for a medium-term hit worth tens of thousands of pounds highlights that the decision to access your tax-free lump sum is not one that should be taken lightly under any circumstances, whether there are rumours swirling or otherwise,” he said.

Tax on savings

The analysis from AJ Bell showed that not only could someone aged 55 taking their pension tax-free lump sum early miss out on pension pot growth, any money transferred into another account could be liable for savings tax.

For example, if the money were added to a cash savings account, it would be subject to the Personal Savings Allowance (PSA).

Basic rate taxpayers can earn £1,000 a year in savings interest before being subject to tax while those in the higher rate band can earn £500. Someone in the additional rate band gets no allowance.

A recent FOI obtained by HMRC by AJ Bell showed pensioners make up 44% of all taxpayers hit by tax on their savings interest.

Meanwhile, money from the pension tax-free lump sum which is invested in the stock market could see the owner subject to capital gains tax or dividend tax, even if it was eventually moved into an ISA.

AJ Bell said this was because a lump sum would have to be added to ISAs over several years, as the current annual limit is £20,000 – leaving a portion of the money exposed to tax in the meantime.

Selby said: “It is crucial to have a clear plan for your money when accessing your pension, either by taking a lump sum or a regular income.

“While you may wish to put that money towards paying off the last of a mortgage or other debts, leaving money in your pension until you need it is often the best course of action.

“It can continue to grow tax free, meaning you should be able to take a bigger tax-free cash lump sum in a few years’ time.”

Source: AJ Bell. *Assumes 6% investment growth in the pension and stocks and shares ISA after charges and that the individual is a higher rate taxpayer who continues working full-time until age 65, but no longer contributes to their pension. Cash account and cash ISA assume an interest rate of 4%. Both Cash and Stocks and Shares ISA scenarios involve drip-feeding lump sum into the ISAs in £20,000 chunks each year (in line with the annual ISA allowance of £20,000) until all the cash is invested in the ISA.

Dangers involved in taking out the 25% tax-free pension early

Anyone considering taking out their 25% tax-free lump early should factor in a number of potential downsides beforehand.

1. Money taken out of a pension can’t grow

Taking 25% of your pension pot tax-free will still leave 75% invested and with the potential to continue compounding and growing, but you could end up with even more by leaving all of it in.

2. Money in a pension is currently not subject to inheritance tax

Pensions are set to be subject to inheritance tax (IHT) from April 2027.

However, if you died before this date, money from a defined contribution pension scheme should be able to be passed to your beneficiaries without incurring a IHT bill.

Whereas any money outside of your pension pot could be counted as part of your estate and IHT would apply.

3. You could end up with less money overall in the long term

Withdrawing your lump sum early might unlock much-needed cash now, but it could leave you struggling down the line as you’ll be spreading your pension pot across a longer period.

Pension calculators like those on the moneyhelper website can forecast how much you are likely to have based on any workplace and personal pensions and state pension.