- The last two Budgets have seen countless rumours around the fate of pension tax-free cash prompt more savers into taking their 25% lump sum early
- AJ Bell analysis of FCA data indicated an excess of £10 billion was withdrawn from pensions ahead of the first Labour Budget in 2024 alone – with new figures tomorrow expected to show another jump in 2025
- A DWP survey in 2024 found that one in four people (25%) taking all their tax-free cash from a pension used it for a one-off purchase
- The Pensions Commission calculated that if people take their tax-free cash and spend it, an extra 2 million will have a pension shortfall in retirement
- A rash decision to take a lump sum early could leave pension savers worse off by tens of thousands of pounds compared with if they’d waited, as well as mean they lose out on growth and pay too much tax
Sarah Coles, head of personal finance at AJ Bell, comments:
“Tax-free cash lump sums from our pensions have become as much a part of our 50s and 60s as protein supplements and joint pain. The vast majority of people take some tax-free cash from their pension, and millions do so before they reach retirement age.
“There will be some people who have drawn up their plans carefully, for whom this makes perfect financial sense. However, there are others taking it purely because of worries about what might lie in the Budget – particularly in the past two years – who could be doing immeasurable damage to their retirement income. There are five expensive choices nobody should rush into.
- Taking tax-free cash as early as possible
“Under current rules, you can take up to 25% of your pension tax-free from age 55 – rising to 57 in April 2028 – capped at a total limit of £268,275 across all your pensions. The risk is that people take everything they can, as early as possible, either because they don’t trust pensions or they don’t trust the government not to mess with tax-free cash in the Budget.
“This has been a particular risk for the last two years, as Budget rumours led people to pull the trigger early, and in 2024, the DWP found that among those who had accessed their pension, a third of people did it between the ages of 55 and 59. It’s why it’s so important that the government rules out changes to the tax treatment of pensions as soon as possible.
“If you have no specific reason for taking the money, dipping in early means you’ll have needlessly restricted the total you can take free of tax. If your fund is worth £400,000 at the age of 55, you can take £100,000 in tax-free cash. If you were to leave it untouched to the age of 65, and it grew at 6% a year net of charges, your pot could be worth £716,339, at which point you could have taken £179,085, or £79,085 more than at age 55.
- Spending it and missing out on growth
“There’s a risk that people mentally account for this cash differently to the rest of their pension and see it as money to spend on today’s priorities, without fully considering the impact on tomorrow. The DWP’s study in 2024 found that one in four people who took the full 25% said they used it for a one-off purchases – as did 37% of those taking a partial lump sum.
“If you were to take out your lump sum and spend it, it can have a horrible impact on your overall pension pot. It’s not just the money you withdraw, it’s the potential growth you lose too. If, for example, you had a pot of £400,000 at the age of 55, which grew untouched at 6% for 10 years, the pot could grow to £716,339. If you took the £100,000 and spent it, your £300,000 could grow to just £537,254 over a decade.
- Spending it when you need it to produce annuity income
“Typically, the decision over whether to take your tax-free cash before getting an annuity will come down to deciding whether the lump sum today is worth more to you than the income in future. However, when you have a smaller pot, you also need to consider whether taking the cash will leave you short.
“If you assume someone needs £40,000 a year to cover their costs in retirement and has a pension pot of £500,000, given that at the moment a competitive level annuity for a single person at the age of 65 pays around 8%, they could use all of it to generate the £40,000 income. However, if you take tax-free cash of £125,000 and spend it, you’re left with £375,000 for the annuity, and an annual income of £30,000 before tax.
“Even if you held the tax-free cash back to supplement your income each month, it might last 12 and a half years, so you still risk running out of money in your late 70s.
- Taking it early on the basis you can reinvest it
“The DWP found that 21% of those taking their full lump sum invested it, and 22% of people taking a partial lump sum did the same. It means taking investments from a tax-free environment and exposing them to tax – at least for a period – in order to simply invest again. Those opting for this route should make sure it aligns with their wider retirement strategy, as they could otherwise choose to leave the money uncrystallised in their pension and take lump sums whenever they needed it instead – without leaving the tax protection of a pension.
“If they don’t use a Stocks and Shares ISA, they will expose themselves to capital gains tax and dividend tax. If they do use an ISA, they will need to gradually move their money into it at a maximum rate of £20,000 a year. If they leave the money in cash in the interim it will grow more slowly, and attract tax.
- Taking it early and leaving it in cash
“Among those taking all their lump sum, the DWP research showed the most common place to put the money was in cash savings, which 37% of people opted to do. This can feel safer, but will severely restrict your growth potential. If they don’t use an ISA, they could also pay tax on interest, and if they gradually moved it into Cash ISAs, it would still be exposed to tax for a period.
“If you saved £100,000 in cash savings and made 4% a year between the ages of 55 and 65, it could be worth £128,995 after higher rate tax – so you’re missing out on over £50,000 of potential growth compared with leaving it in a pension and taking a lump sum at age 65.
Is it a price worth paying?
“This doesn’t necessarily mean taking some tax-free cash earlier in retirement is always wrong, you just need to understand the price you’re paying. You may, for example, want to phase retirement, so you withdraw tax-free cash from one of your pensions in order to supplement your income when you move into part-time work, before your state pension is due. Alternatively, you might want to take some cash to pay off your mortgage and cut your monthly costs, so you can afford to live off a part-time income.
“You might also plan to take tax-free cash gradually through phased drawdown and use it to invest in Stocks and Shares ISAs, so your money grows tax efficiently and can be used to supplement your pension income tax free. Alternatively, phased drawdown can mean you use it for one-off costs as you go along – like home adaptions or a replacement car.
“If you need the whole pension to produce an income for life, you could even take the tax-free cash and use it to buy a purchased life annuity, where some of the income will be tax free. That can run alongside your taxable pension income, cutting your tax bill.
“We all need to find the solution that’s right for us, but before you consider any of these options, you need to understand the price you’ll be paying.”
