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Taking tax-free cash from a pension

What is the tax-free pension lump sum?

The pension commencement lump sum (commonly known as tax-free cash) is the amount of money available to you free of any tax once you reach the minimum pension age, which is currently 55 (set to rise 57 in 2028). It can be a substantial bonus when you retire after saving throughout your working life, and has lots of potential uses.

How is it calculated?

If you have a personal pension – such as a Self-Invested Personal Pension (SIPP) or workplace pension – the fund’s value is determined by the investments that you hold. The tax-free cash is simply up to a quarter (25%) of the fund’s total value when you decide to take the money.

If you have a final salary pension, most schemes also allow members to draw a one-off tax free lump sum. Sometimes this lump sum is offered at the cost of receiving a smaller starting pension. For other schemes the lump sum is automatically offered in addition to your guaranteed pension income.

Should I take a lump sum or keep it invested?

Once you reach the age of 55, you’re usually free to take money out of your personal pension(s) – as much as you want, whenever you want. Of course, if you have no immediate plans for the money you can leave it invested. As long as your money stays in your pension pot you won’t pay tax on it and you’ll get tax-relief on contributions you make.

There are three reasons why it’s not a good idea to take out more tax-free cash than you need:

  1. Whatever you take out loses the tax advantages of pensions. Any interest that the money earns (e.g. in the bank) could be subject to income tax. If you invest it outside of an ISA then it will be subject to capital gains tax. It will also become part of your estate for inheritance tax purposes.
  2. Leaving your money in an invested portfolio gives you the benefit of compounded investment returns. An extra 10 years of growth can make a big difference to your retirement income.*
  3. For every pound you take out of your pot, £3 of what’s left gets ‘crystalised’. From then on, even if your pension fund continues to grow, whatever that £3 is worth it won’t generate any more tax-free cash for you. So the more tax-free cash you leave in your pension today, the more you should be able to take out tomorrow.*

In a nutshell, if you don’t have an immediate need for your tax-free cash it is usually better to leave the money invested in your pension.

* Past performance is not a guide to future performance. The value of investments and the income derived from them may go down as well as up, so you could get back less than you originally invested.

What other options do I have?

There’s nothing to stop you taking your tax-free lump sum while continuing to work. If you’re in a modern, flexible pension, you can take your tax-free cash while continuing to make contributions into your pension (although see point 3, above).

There are rules to stop you ‘recycling’ your tax-free cash into new pension contributions though so you should take advice if this applies to you.

You can also draw a combination of tax-free cash and taxable income from your pension: if you drew £10,000 in this way you would receive £2,500 tax-free and the other £7,500 would be subject to income tax. Spreading withdrawals over a number of years can minimise your tax bill and while spreading your tax-free entitlement over several years. It also means your remaining tax-free cash entitlement will continue to grow.

If you take any taxable income from your personal pension the amount you can pay into a pension to earn tax relief falls to £4,000 a year. You should take advice if you are considering this.