Pension pitfalls to avoid as Budget rumours prompt panic

The Budget rumour mill started early this year, and with the fiscal event not taking place until 26 November, we can expect nine more weeks of frenzied speculation. Pensions are often at the centre of the media storm.

The nervousness is unsurprising. Weak economic growth and high borrowing costs mean tax rises are likely, and the government may need to be creative given its promise not to touch the three main working taxes.

While reading up on possible changes can help you prepare your finances, rushing into irreversible decisions is often a bad idea.

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Recent data shows pension tax-free cash withdrawals surged 61% last year in a Budget-related frenzy. While some savers would have had a plan for their cash, others were driven by fear that the tax-free allowance would be cut – a policy that never materialised.

“Concerns before the last Budget that tax-free cash could be cut have resurfaced this year, and savers who are worried about this are taking their pension commencement lump sum, or thinking of doing so,” said Philip Lewis, head of financial planning advice at Evelyn Partners, a wealth management firm.

“However, those who are accessing their pension fund without taking advice could be making some serious errors that leave them counting the cost later in retirement.”

1. Don’t take tax-free cash without a plan

When you withdraw money from your pension, you take it out of a tax-efficient environment and move it into one where a tax bill may be generated – for example on savings interest, or dividends and capital gains if you decide to reinvest the money outside an ISA.

Withdrawing your tax-free cash and sticking it in a savings account also means you miss out on the potential for future investment growth.

“Taking the tax-free lump sum is best done as part of a plan, with a picture of how your future years of retirement will be funded, and it’s hard to beat cash-flow modelling from a professional financial planner for that,” Lewis said.

“It also helps if there is a clear purpose for the sum, such as paying down the mortgage, gifting, or taking an income.”

There is no obligation to take your full tax-free lump sum in one go either. You can take it gradually in instalments as 25% of each withdrawal. That way, the tax-free portion of your pension pot continues to grow, provided your pension achieves decent investment growth.

2. Beware of pension recycling

Some might be under the misconception that they can withdraw their tax-free cash and then simply reinvest it if the allowance isn’t cut at the Budget, but they need to be careful.

“There’s every chance you could fall foul of strict pension recycling rules that could see you clobbered with a substantial tax charge,” warns Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, the investment platform.

Recycling rules are in place to prevent people reinvesting their tax-free cash to benefit from pension tax relief on the same money twice.

The penalty charge depends on how much money you recycle. If the money taken is less than 25% of the pension value, you will usually be slapped with a 40% charge. If the sum is larger than this, an additional 15% surcharge will typically apply.

3. Don’t unknowingly trigger the money purchase annual allowance

When you start taking taxable income from your pension, you trigger something called the money purchase annual allowance. From this point, your annual pension allowance drops from £60,000 to £10,000.

While you can still pay in more than these amounts, you won’t qualify for pension tax relief on the contributions. See our explainer for how pension tax relief works and why it is so valuable.

“FCA data suggests that at least 54% of those who accessed a pension for the first time in 2024/25 did so in a way that would trigger the money purchase annual allowance,” said Lewis.

This could be a problem if you are still working and want to continue paying into your pension. Some people go part time to ease into retirement, while others decide to return to work after a brief pause to bolster their pension savings.

4. Don’t be deterred from pension saving

Rumours about cuts to pension tax relief also tend to do the rounds before a Budget event. Currently, savers receive tax relief on pension contributions at their marginal rate – 20%, 40% or 45%.

Some argue that high earners shouldn’t be entitled to full tax relief. Proposals usually focus on getting rid of the higher rates (i.e. entitling all savers to just 20%), or introducing a flat rate for everyone (say, 30%).

Morrissey points out that rumours can be damaging, acting as a disincentive to save. “Pension investors need certainty over the tax system so they can plan for the future,” she said.

Most people underestimate how much they will need for a comfortable retirement, so don’t let rumoured changes put you off. If anything, most advisers recommend upping your contributions above the standard 8% pension rule, if you can afford it.