Your maximum tax-free lump sum from each would be:
Pot A lump sum:
£12,500 (25% of £50,000)
Pot B lump sum:
£20,000 (25% of £80,000)
Pot C lump sum:
£30,000 (25% of £120,000)
So your total maximum lump sum allowance across the 3 pots would be £62,500, in this case.
Are there any restrictions or limits on pension lump sums?
While pension lump sums provide useful flexibility, there are some restrictions and limits you need to consider:
The 25% rule
As outlined earlier, 25% of your total pension savings is the maximum tax-free lump sum you can take from any single pension pot. It's very rare for schemes to allow more than 25% to be taken tax-free.
Money Purchase Annual Allowance
Before you begin to withdraw money from your pension, or if you only withdraw up to your 25% tax-free cash allowance, the amount you can contribute to your pensions each year while still receiving tax relief is £60,000, or 100% of your annual earnings, whichever is lower (2023/24). If you withdraw more than your 25% tax-free allowance, the amount of money you can contribute while still receiving tax relief reduces. This is known as the Money Purchase Annual Allowance (MPAA). The annual allowance decreases to £10,000 per year (2023/24) when you begin to withdraw from your pension. This allowance is only applicable to defined contribution pensions.
This restriction is designed to limit pension recycling, where people withdraw money tax-free and then top their pension up again.
You should consult with a regulated financial adviser to see how the MPAA could impact you.
Pension type restrictions
You cannot normally take tax-free lump sums from the State Pension, public sector occupational schemes like the NHS, civil service or teachers, or if you have already used your pension to purchase an annuity.
Some older workplace pension schemes also have their own specific rules around taking lump sums that may be restrictive, so always check with the provider.
Should I take a pension lump sum or leave my pension invested?
Deciding whether taking a tax-free lump sum is right for you is a complex decision that depends on your individual financial situation and priorities. Here are some of the key points for and against:
Potential benefits of withdrawing a lump sum
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Tax-free cash - this can be put towards paying off debts, home improvements, gifting money to family, supporting immediate financial needs or anything else you choose.
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Flexibility – you can withdraw as much or as little as you want. Of course it is important to remember that after you withdraw your 25% tax-free amount, the rest is taxable. Anything that you don’t withdraw remains invested.
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Provides inheritance tax planning options - any unused pension funds on death can pass tax-free to beneficiaries if you die before 75. This can provide inheritance tax advantages as pensions sit outside of your estate.
Risks and downsides of withdrawing pension lump sums
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Reduces future retirement income - the more you withdraw now, the less you will have remaining to generate income in your later years. This could negatively impact your lifestyle. Withdrawing money from your pension early will leave you worse off in retirement.
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Impacts means-tested benefits - taking substantial lump sums could take you over the savings thresholds for means-tested state benefits, if you are entitled to any.
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Limits future pension contributions - once you take a lump sum that exceeds your 25% tax-free allowance, your annual allowance drops to £10,000 per year, meaning the amount you can contribute to your pension whilst still receiving tax relief decreases.
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Potential annual income tax personal allowance implications - if your annual income, including salary and any pension income, is below £100,000 per year, then your annual income tax personal allowance will not be affected. However, once you start earning £100,000 or more, your personal allowance steadily decreases until you reach £125,140, at which point, you no longer receive tax relief on any of your earnings. So, if you withdraw a large pension lump sum and this takes your total annual income over £100,000, your income tax annual allowance will be affected for that year.
As you can see, there are positives and negatives to weigh up when deciding whether or not to access your pension lump sum entitlement. Seeking regulated financial advice can help assess the pros and cons of lump sum withdrawal in relation to your specific situation.
How is a pension lump sum taxed?
One of the big advantages of taking a lump sum from your pension is that the first 25% is tax-free. This applies regardless of whether you take the full 25% or a smaller percentage.
For example, if your total pension savings are £80,000 you could choose to take:
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The full 25% tax-free lump sum of £20,000
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A smaller tax-free lump sum of say £10,000 (12.5% of your fund)
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No lump sum at all if you prefer
The key fact is that as long as the amount you withdraw is within the 25% limit of your total pension savings, it will not be taxed. This applies even if:
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You take the lump sum while still earning other taxable income from a job
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Your total income for the year exceeds the higher or additional rate tax thresholds
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You are drawing taxable income from other pensions at the same time
Any pension withdrawals you make above the 25% tax-free amount will be taxed as income at your marginal rate, so taking large cash sums could push you into a higher income tax bracket.
The tax treatment is the same whether you are retired or still working. The key fact is that the first 25% of your total pension savings qualifies as tax-free cash.
All our opinions regarding taxation and related matters are based on our understanding of the current tax law and practice of HMRC, which is subject to change. Speaking with your pension provider and a regulated financial adviser can help to make sure you have all the relevant information regarding your lump sum entitlement.
Any pension withdrawals you make above the 25% tax-free amount will be taxed as income at your marginal rate, so taking large cash sums could push you into a higher income tax bracket.
Defined benefit pension lump sums
Defined benefit or final salary schemes provide a guaranteed income in retirement based on your salary and years of service. The guaranteed income is agreed by your pension provider and usually increases each year in line with inflation. Defined benefit schemes differ from defined contribution schemes which have a clear pot of funds available and are relatively easy to withdraw lump sums from. On the other hand, defined benefit pensions are much more complicated.
You cannot withdraw a lump sum early from your defined benefit pension. You would first need to transfer to a defined contribution pension, which is often not advised as you would be losing the valuable guaranteed benefits that come with your defined benefit pension.
Upon retirement, in some cases you can withdraw a lump sum from your defined benefit pension. To determine your lump sum entitlement, firstly, it is important to understand how your DB pension income is calculated. This is dependent on your provider, but the below is a helpful example for final salary pension schemes*:
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John is about to retire
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He’s been a member of his employer’s final salary pension scheme for 40 years
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The scheme’s accrual rate for building up his pension is 1/80th for each year’s membership
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John’s final pensionable earnings are £30,000 a year
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This means that John can receive a pension of £15,000 a year (40/80 x £30,000) from the scheme
*This example was taken from moneyhelper.org.uk
The above is just an example. Consulting your pension provider or a regulated financial adviser can help to offer insight into what the calculation will look like for your scheme.
Your lump sum is dependent on the amount agreed with your pension provider and your guaranteed income amount. Your scheme should outline the maximum amount of tax-free cash you can take.
Always check the specific rules with your pension provider as they can differ between defined benefit schemes. It is also important to note that in most defined benefit pension cases, your annual income from your pension will reduce if you take a lump sum. The amount that it is reduced by is referred to as the commutation factor. This is not the case for all defined benefit pensions. The specifics should be outlined by your scheme provider so it is important to check with them directly.
Taking a lump sum from your pension will leave you worse off in retirement, and the calculations can be complicated. It is important to consult with a regulated financial adviser to make sure you are aware of all the options available to you.
Defined benefit beneficiary tax rules
Unlike defined contribution schemes, where the amount of money in your pot depends on how much you have invested and how those investments have performed, defined benefit pensions promise to pay you a guaranteed income for life from a set age. In many cases, when you die a proportion of that guaranteed income will continue to be paid to your spouse or partner. Rules vary from scheme to scheme. So, it is important to speak with your pension provider or HR team to understand the specific rules that apply to you.
How to use pension lump sums for effective retirement planning
Taking a tax-free lump sum from your pension can be a useful part of an effective long-term retirement plan when done correctly. Here are some tips:
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Don't rush into taking it - wait until you have a clear purpose for using the money rather than just taking it because you can. Withdrawing funds early from your pension will leave you worse off in retirement.
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A regulated financial adviser can make you aware of options for managing tax liability if you have several pension schemes.
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Shop around for the best annuity rates first if you plan on using some of your lump sum to buy an annuity. The annuity provider does not have to be the same as your pension provider. A regulated financial adviser can help you to make sure you are getting the best deal.
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Get professional advice before withdrawing money from a final salary pension scheme - you risk giving up very generous and valuable guaranteed benefits if you transfer out. Make sure you fully understand the impact.
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Using lump sums to pay off debts, like mortgages, before retirement can mean your retirement income goes further each month as your regular outgoings, such as debt repayments, are reduced.
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Consider topping up your State Pension if you have gaps in your National Insurance record. You can check your National Insurance record to find out if you have any gaps, if you’re eligible to pay voluntary contributions, and how much it will cost.
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Review all your assets, savings, and income sources and put a detailed financial plan in place for your retirement years.
Taking the time to think through your overall retirement finances, rather than just reacting to the option of having some tax-free cash, will help ensure your lump sums give you the best chance of a comfortable retirement. It is always worth consulting a regulated financial adviser to support you with making the best decision for your particular circumstances.
Frequently asked questions on pension lump sums
