Tax-free income is getting vanishingly rare as allowances have been repeatedly squeezed by successive governments. But Britain’s favourite tax-free perk seems virtually untouchable – the 25% pension tax-free lump sum.
Most savers can put up to £60,000 a year into a pension without having to pay tax – known as the annual allowance – and can access their defined contribution (DC) pot from age 55 (although this is rising to 57 from 6 April 2028).
When accessing your pension for the first time, you can also get up to a quarter of your pot completely tax-free, known officially as the pension commencement lump sum (PCLS).
Try 6 free issues of MoneyWeek today
Get unparalleled financial insight, analysis and expert opinion you can profit from.
Start your trial
Sign up for MoneyWeek’s free twice-daily newsletter.
Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
Tax-free pension cash acts as a powerful psychological anchor for many over-55s as they approach retirement, according to research from the Standard Life Centre for the Future of Retirement.
Latest Videos FromMoneyWeek
Two-fifths (42%) said they either plan to take the full lump sum in one go or have already done so, in the research conducted among 2,000 UK adults aged 55-70 with a defined contribution pension in February 2026.
Among those who are planning to take the 25% tax-free lump sum in one go, more than two-fifths (44%) say it will mark the start of their journey towards retirement.
A third (32%) say it will give them a sense of financial security and a fifth (21%) say they view it as a separate pot of money entirely.
However, Tom Selby, director of public policy at AJ Bell, warned it might not be right for everyone. He said: “Just because you can do something doesn’t necessarily mean you should.”
“Before taking your tax-free cash, make sure you have a plan for the money. If, for example, you take your full entitlement out and then just shove it in a bank account, the money will risk being eaten away by inflation over time,” he added.
We look at how much you need to retire in a separate article.
How does the 25% pension tax-free cash work?
Pension income, including both the state pension and private pensions, is usually taxed at your marginal income tax rate – 20% for basic, 40% for higher, and 45% for additional rate taxpayers.
But a special privilege of pensions is you can take some of the money free of income tax, an attractive reason for contributing to pensions in the first place.
If you have private pensions or workplace pensions – as most employed people now do – you can take up to 25% of the total value of all your pension pots completely tax-free. You can either take this all in one go as a lump sum, or in instalments.
What are the pension tax-free allowances?
Usually you would pay income tax on pension income over the personal allowance, currently £12,570 per year.
But when you access your pension you can take up to a quarter of your pot tax-free.
For most people, the maximum tax-free cash they can take over their lifetime is £268,275.
When can I take my tax-free pension cash?
You can take your tax-free pension cash from age 55 currently. This is rising to 57 in 2028. But, said Selby, “there are very good reasons to hold off doing so if you can”.
“Perhaps most importantly, the earlier you start taking an income, the longer that income will need to last – and the less opportunity your fund, including the tax-free cash entitlement, will have to enjoy long-term investment growth.”
To illustrate, AJ Bell gives the example of Sarah, who has a £200,000 pension pot at age 55. If she decides to access her retirement pot as soon as she can, Sarah could get £50,000 of tax-free cash, with the remaining £150,000 available to deliver a taxable income.
If we assume Sarah chooses to keep her fund invested through pension drawdown and enjoys investment growth of 4% per year after charges, she could take an annual income of around £7,600, with her fund exhausted by around their 90th birthday.
But Selby said: “If, however, they held off accessing their pension until age 65 and enjoyed 4% annual growth during that period and in retirement, they could generate around £74,000 of tax-free cash and enjoy an income of around £13,300 a year until age 90.”
Can I take my pension tax-free cash in instalments?
You don’t have to take your pension tax-free cash all in one go – you can choose to take your tax-free cash in chunks instead.
You can do this by just taking ad-hoc lumps of tax-free money.
Or by taking some of your withdrawn portion as tax-free cash (25%), with the rest (75%) going into drawdown taxed at your usual rate of income tax when you take it as income (until then it stays invested). This is known as uncrystallised funds pension lump sum (UPFLS).
Take, for example, someone with a £100,000 pension who needs £5,000 of tax-free cash. Rather than taking their entire £25,000 tax-free cash entitlement all in one go, they could just commit £15,000 to drawdown (75%), which would then release the £5,000 tax-free cash they need (25%).
This would leave the remaining £80,000 – including the 25% tax-free cash entitlement attached to it – free to grow over the long-term.
This process of taking pension 'slices' can then be repeated as many times as you wish until your total tax-free amount is used up. But using UPFLS will trigger the money purchase annual allowance (MPAA), limiting how much you can put into your pension per year to £10,000.
The process of UPFLS pension slicing should be relatively straightforward. You’ll just need to tell your pension provider how much of your pension pot you want to commit to drawdown and as a result how much tax-free cash you would like to take. Your provider should already have details of the bank account they should pay it into.
Committing to drawdown doesn’t mean you have to access your taxable income immediately – in fact, it’s often sensible to drip feed withdrawals slowly as you need the money to keep your income tax bills as low as possible.
If your provider doesn’t offer drawdown and this is your preferred retirement income route, you may need to consider transferring your pension to a low-cost platform that allows you to take income in this way.
Before transferring, check you won’t be hit with exit charges or lose valuable guarantees attached to your pension plan. Your existing provider should be able to tell you if this is the case or not.
What do I do with my pension after taking the tax-free cash?
If you do decide to take out your 25% tax-free lump sum, one of the issues to think about is what you do with the other 75%.
You don’t need to take all of your pension in full to access your tax-free cash – but many people do and it costs them.
The Financial Conduct Authority (FCA), the watchdog, has found more than a third (35%) of people who cashed out their pension in full put the balance into a current account or cash account.
This is typically not the most sensible option. It makes sense to keep the money invested and growing – tax-free – inside your pension, which will provide you with a bigger financial war chest to support you in retirement.
Does taking your pension tax-free cash stop you using carry forward allowances?
Carry forward rules enable you to mop up any unused annual pension allowances from the three previous years once you have maximised your current tax year’s allowance – £60,000 for most people – as long as you have sufficient relevant earnings in the current tax year.
Andrew King, pensions technical specialist at Evelyn Partners, said: “Taking a tax-free cash lump sum does not prevent you from making use of carry forward – unless you have triggered the money purchase annual allowance (MPAA) by taking other funds out as well as the tax-free cash.”
The MPAA limits the amount you can put back into your pension to £10,000 a year once you have started taking an income from it beyond just taking tax-free cash. If you take your pension tax-free cash via UPFLS this will trigger the MPAA.
However if by using carry forward you exceed the limits set out in the pension recycling rules then there is a chance you could be penalised. “For instance, making a very big one-off contribution using carry forward allowances and then taking tax-free cash shortly after could risk a penalty,” said King.
Pro and cons to consider when taking tax-free cash
The tax-free lump sum is often seen as a tangible reward after a lifetime of saving. Many people mentally separate the lump sum from the rest of their pension, treating it as a bonus earmarked for big financial decisions.
Often people prioritise simplifying their finances before retirement, using the lump sum to reduce debt or pay off a mortgage in order to create a “clean slate”. It’s worth weighing up the pros and cons before you act.
Pros
- You can spend the money as you wish and pay no income tax on it
- This can include paying down debt like mortgages or other loans
- You can take the 25% tax-free in instalments, leaving more of it invested to continue to grow tax-free in your pension
Cons
- Taking the full 25% pension tax-free lump sum without a plan and sticking it in a low interest savings account can mean inflation eats away at your money
- You may have to pay savings tax on interest if you put the full lump sum in a non-ISA account
- You will have less of a total pension pot with which to buy an annuity – meaning if you do buy an annuity later, you’ll probably get less annual income
According to Standard Life’s polling, the majority (90%) of 55-70-year-olds say they want their finances to be as simple as possible before retirement. The research also found that more than two-thirds (68%) feel confident about deciding how and when to take their tax-free cash.
The intended use of tax-free cash varies, but the findings suggest many approach it with a clear purpose in mind. More than a quarter of those who plan to take a lump sum (28%) expect to use it for an expensive treat such as a car or holiday, while the same proportion plan to use it as initial income for day-to-day expenses before they access the rest of their pension.
More than one in five (22%) plan to reinvest it elsewhere, and 17% want to reduce their working hours and top up their income with it. Less than one in 10 (9%) say they have no particular use in mind.
