For many savers, being able to take 25% of their pension savings as a tax-free lump sum when they reach retirement is one of the main attractions of private pensions.
While there are many potential uses for this money – from paying off a mortgage, helping grown up children or spending it on travel – you don’t have to take it all at once. In fact it may make sense to opt for instalments instead.
For one thing, money left in your pension fund can continue to be invested. If you withdraw 25% of your pension savings, you're immediately reducing the value of your pension pot and taking away the chance for that money to grow further.
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Plus, if the investment markets have been volatile and reduced the value of your pension, leaving some of those savings invested could mean they benefit from any future recovery, and mean you are better off overall.
Equally, by taking your tax-free cash in instalments, rather than upfront, you can use it to supplement your pension income. This may be useful for younger savers waiting for state pension benefits to become available, for example, or simply for anyone anxious about making ends meet.
Another benefit of staggering your tax-free cash is that money taken out of your pension is considered part of your estate for inheritance tax (IHT) purposes.
Savings inside a pension plan, by contrast, can generally be passed on to your heirs with no IHT liability to worry about. If the inheritance tax bill is a potential problem for your family, that may be very valuable.
However, rules surrounding pensions and IHT will change in 2027. In her Autumn 2024 Budget statement, Chancellor Rachel Reeves announced plans to include unused pensions and certain death benefits in the value of a person's estate, for the purposes of inheritance tax. This rule change will take effect from April 6, 2027.
Taking a pension lump sum in instalments: how to organise your pension
If you plan to take your tax-free pension lump sum in instalments, there are a few different ways to organise your pension income. It’s worth highlighting that taking independent financial advice on the best option will make sense for most savers.
The simplest route is to leave your pension ‘uncrystallised’. This simply means you’ll take money directly out of your savings, rather than structuring withdrawals through an income-drawdown plan or an annuity purchase.
Each time you make a withdrawal, 25% of it will be covered by your entitlement to take 25% of the fund tax-free, so there will only be income tax to pay on the other 75%.
The alternative is to use a more conventional drawdown arrangement – known technically as ‘flexi-access drawdown’ – but stagger the transfer of your savings into the scheme. Each time you need some money from your savings, you take a tax-free lump sum directly from your remaining pension fund.
Then, for each £1 taken, you must move £3 into the drawdown plan. You’ll only pay tax on this cash when you withdraw it from that fund. You can keep doing this until you’ve exhausted the funds in your original pension plan.
Is it worth taking my tax-free pension lump sum in instalments?
There are pros and cons to each of these methods for taking your tax-free pension lump sum in instalments. The right option for you will depend on your individual circumstances.
But either way, there’s a good chance you’ll ultimately get access to more tax-free cash than you would have been entitled to by taking the full 25% entitlement upfront. If your pension fund continues to appreciate, so will the cash value of the tax-free portion of it.
Be realistic, however: turning down your upfront tax-free cash may well be a luxury you can’t afford. If the full 25% lump sum is part of your financial planning arrangements as you move into retirement, you’ll need to take it or change your plans. However, if you can afford to do without the full lump sum in one go, instalments have real advantages.
Does tax-free pension lump sum count as income?
No, it’s tax-free.
You'll pay income tax on the remaining 75% of your pension pot, however. The amount of tax you pay depends on your income tax band for that year.
Your pension provider will take any tax from your drawdown income payment before it’s paid out.
How to take a tax-free lump sum from a pension
If you have a financial adviser then this practical side of things can be taken care of by them on your behalf.
If you’re handling your retirement arrangements yourself you can speak to your pension provider directly about accessing your money.
“For defined contribution schemes there’s UFPLS – uncrystallised funds pension lump sum,” says Laith Khalaf, head of investment analysis at AJ Bell.
“This is a cash withdrawal from your pension scheme, 25% of which is tax free, and the rest stays put.
“Alternatively you can buy an annuity and take your 25% at this point. Or go into income drawdown where you can take some or all of the tax-free money and leave the rest invested while taking an income – large or small. You could also do a mix of the two.”
Whatever you decide, your provider will tell you what you need to do which might be as simple as filling out an online form. The process will vary between providers.
Remember, you can only do this once you’ve reached the age of 55 (rising to 57 from April 2028).
Final salary schemes also known as defined benefit, typically pay a scheme pension, which is a pre-determined income for life, plus a pre-determined tax-free lump sum.
Khalaf adds: “There is normally a scheme retirement age and the payment would only get automatically triggered at that point. If you retire before this date it may be possible to take your pension earlier but with a reduced income.
"Conversely if you retire later some schemes may let you continue to roll up your pension beyond the scheme retirement age and build up further benefits.” You’ll need to speak to the pension scheme department.
How much can I take from my pension tax-free?
Typically you can take up to 25% of your total pension savings tax-free.
There are limits in place – the most you can take is £268,275, though your tax-free amount may be higher if you hold a protected allowance. These limits won’t affect most savers – they apply to those with pension pots upward of £1 million. The average pension pot in the UK is around £20,000, according to PensionBee.
There are some exceptions for the 25% limit. Some old-style workplace pensions with ‘protected tax-free cash’ might allow you to take a higher proportion than 25%. You’ll need to speak to your scheme provider about this.
You may be able to take all the money in your pension as a tax-free lump sum, if you’re terminally ill. To be eligible you should be expected to live less than a year because of serious illness, be under the age of 75 and for the amount to be below your lump sum and death benefit allowance.
Is the 25% tax-free pension lump sum under threat?
Since this pension perk is so valuable, there is often talk that it could be changed or removed entirely.
Most recently there were rumours that the pension tax-free lump sum was under threat in the run up to Labour’s first Budget in October 2024.
It’s important to remember that tax rules and allowances can and do change over time so it’s important to maximise them while they are around.
Beware of pension scams
Fraudsters often target people planning to withdraw money from their pension so be wary of any cold callers offering their services. Scams include a cold caller claiming to know about loopholes that can help you get more than the usual 25% of your pension pot tax-free. As part of this scam they might persuade you to transfer your pension to them which can lead to losing your life savings overnight.
Many fraudsters clone the websites of genuine pension firms and extract money by pretending to be part of that firm and offering to take charge of their pension savings.
Some might also promise to help you take your pension savings before you reach 55.
Since January 2019, there has been a ban on cold calling about pensions so unless you’ve asked someone to contact you, any caller is likely to be a fraudster.
Remember, don’t be pressured into making any decisions – alarm bells should ring if someone tries to rush you into agreeing to something.
Take time with your pension planning and if necessary enlist the help of a professional adviser. You can find one in your area at unbiased.com.
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