Pension tax-free cash: do you have a plan for yours?

How will you spend your pension tax-free cash – book a once-in-a-lifetime trip, buy a new car, or finally knock down that wall and fit a new kitchen? You might even use it to fund an early retirement.

Tax-free cash has become an almost sacred part of the UK pension landscape, as was evidenced by the furore that followed a think tank’s proposal to cap tax-free cash at £100,000 last year (which, thankfully, wasn’t acted on).

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For lots of savers, the ability to take 25% of their pension as a tax-free lump sum provides a much longed for windfall, not to mention an incentive to pay as much as they possibly can into their pot.

In fact, figures from Scottish Widows show that, across its pension book, twice as many people take tax-free cash out of their pension at 55 (the earliest you can access it, rising to 57 in 2028) than any other age.

However, you don’t have to take your tax-free cash as soon as you turn 55, or even when you finish working. Nor do you have to take it all in one go.

In fact, there could be a strong argument for taking your tax-free cash gradually or leaving it untouched until later in your retirement (if your scheme permits it).

So, here’s what you need to know about tax-free lump sums, before you take yours.

Tax-free cash: the rules

When you reach age 55, pension rules allow you to take 25% of your pension as a tax-free lump sum (officially referred to as your pension commencement lump sum, or PCLS).

However, if you have impressive retirement savings, it’s worth noting that the amount you can take out of your combined pensions tax-free, is usually capped at £268,275 (your lump sum allowance), following the abolition of the lifetime allowance in 2024. Some people with larger pensions may have a higher protected allowance.

Tax-free cash is available whether you have a defined contribution (DC) pension - including personal pensions, group personal pensions and self-invested personal pensions - or a defined benefit (DB) scheme.

However, with DB schemes, different calculation methods are used. As this type of occupational pension pays a guaranteed income for life, it’s harder to accurately calculate 25% of its value.

As such, DB schemes will either let you “commute” some of your retirement income in return for tax-free cash (typically between £12 and £15 of tax-free cash for every £1 of retirement income you give up) or pay a separate tax-free lump sum in addition to your income. The latter is more likely if you’re a member of a public sector pension.

It’s important to check how your scheme works. DB schemes have different rules; you may also find payments are less flexible than DC pensions.

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Should you stick or twist?

Before making any decisions, Robert Cochran, retirement specialist at Scottish Widows, says it’s important to think about whether you’re taking money out of a DC or a DB scheme.

“If the source of your money is a defined contribution scheme, before accessing tax-free cash, it’s a good idea to think about what you’re going to do with it and also the remaining money that's left behind. Remember that the money you take out of a pension wrapper is coming out of a tax-advantaged environment and if you’re putting it somewhere like your bank account, you may be paying tax on any interest that you get on the cash. A good rule of thumb would be to take it if you are going to spend it and consider paying off your mortgage or other loans.”

He adds: “In a final salary scheme [DB], each scheme does its own calculation as to how much income you give up to tax-free cash – so this requires some considerable thought and it might be better to maximise income from final salary schemes and access tax-free cash from other arrangements.”

You should also consider the impact that taking your cash will have on your future retirement income. The more you take now, the less you’ll have to fund later life.

“Delaying taking tax-free cash can be beneficial if you do not have an immediate need for the funds,” says Alan Barral, a financial planner at Quilter Cheviot. “It allows the invested portion to remain in the market for longer, potentially growing further.”

Although this does carry a degree of stock market risk, if time is on your side, you should ideally end up with more tax-free cash as a result.

However, Barral adds that it may not make sense to leave your tax-free cash indefinitely – especially if your pot is on the larger side.

“If you wait too long, you risk running into the age 75 cut-off, after which the tax treatment changes and you may lose the benefit.”

If you die before age 75, all your remaining pension can be passed income tax-free to your chosen beneficiaries. After this point, any withdrawals will be taxed at their highest rate of income tax.

Should you stagger your tax-free cash?

Another point to consider is that with DC pots, you don’t have to take your lump sum in one go.

While lump sums can help you manage big expenses, the benefits of taking tax-free cash gradually over time shouldn’t be overlooked – especially if you want to minimise your tax bill.

By using tax-free cash to top up your taxable income, you may be able to reduce the overall amount of tax that you pay. “It will mean that each year you are taking income, some of it will be tax-free, allowing you to manage your tax bands and possibly avoid triggering tax at all,” says Cochran.

Barral adds: “For many, a gradual approach, taking what you need in stages, can help preserve your pension’s long-term value while still giving you flexibility.”

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Don’t confuse tax-free cash with UFPLS

If you want a tax-free lump sum from a DC pot, it’s essential that you withdraw your money in the correct way.

To ensure you don’t end with a tax bill, you’ll need to “crystallise” your pension by moving into drawdown or buying an annuity.

If you take money out of your pension without doing this, it would be considered an uncrystallised fund pension lump sum (UFPLS) withdrawal. This would mean that only the first 25% would be paid tax-free and income tax would be charged on the rest. This could land you with a pretty hefty (and often unexpected) tax bill – especially if the size of your withdrawal nudges you into a higher-rate tax bracket. You may also be hit with emergency tax, although you can reclaim that.

If you want to take your tax-free cash gradually, it’s possible to crystallise your pot in tranches, taking 25% tax-free cash, each time.

Don’t think about your tax-free cash in isolation

The key to making the most of your tax-free cash is not to think about it in isolation, or taking it just because you can.

As Barral says: “It’s important to consider how it fits into your wider retirement plan rather than seeing it as an automatic first step. The amount you withdraw will no longer be invested, so there is a trade-off between enjoying money now and giving it more time to grow.”