Pension lump sums:

The ultimate guide

Pension lump sums are an important part of retirement planning in the UK. This extensive guide covers everything you need to know about taking lump sums from your pension.

Important note: taking pension money early is not right for everyone as it will leave you worse off in retirement. That’s why it makes sense to get regulated financial advice before making any final decisions.
What is a pension lump sum?
A pension lump sum is an amount of money that you can take from your pension in one go. You have the option to take 25% of your pension savings as a tax-free lump sum payment. Any amount you take after this will be taxed at your marginal income tax rate.

For example, if your pension pot is worth £100,000, you could take a tax-free lump sum of up to £25,000. The remaining £75,000 stays invested in your pension fund and is taxed when you eventually withdraw it.

For the purpose of this article, when we talk about pension lump sums, we are talking about this 25% tax-free allowance.

Taking a tax-free lump sum is optional. You can choose to leave your entire pension invested if you prefer and take it as an income later on. But for many people, the tax-free cash option is an important way to access some retirement savings early, often to help out with an immediate financial need, such as paying off debts.
What is a defined contribution pension?
Defined contribution pensions, sometimes called money purchase pensions, are schemes where contributions are invested to build up a pot of money. Your eventual retirement income depends on your contributions, your employer’s contributions (if they have made any), and factors like investment growth.

Defined contribution pensions are some of the most common pensions around, and typically, most of these pensions will allow you to access your tax-free lump sum from age 55 onwards. This is dependent on your specific provider, so it is always best to check with them first.

This article will focus on tax-free lump sums in relation to defined contribution pensions. Other pension types, like defined benefit or final salary pensions, are much more complicated – we will address this separately later in the article.
How do pension lump sums work?
Here's a more detailed look at how taking a lump sum from your pension works:
  • As long as you have an eligible scheme, you can normally take a tax-free lump sum from age 55 onwards (sometimes earlier if you're retiring due to ill health, your pension provider will be able to inform you if you have this option)
  • The maximum lump sum is usually 25% of your total pension savings in each individual pension pot that you have
  • The 25% rule applies separately to each pot - so if you have 3 pension pots, each would have its own 25% allowance
  • You don't have to take the full 25% entitlement - you can choose to withdraw any amount up to the 25% tax-free limit
  • Once you take your tax-free lump sum from a particular pension pot, the remainder of that pot is then taxed as income on any future withdrawals
  • While the lump sum is tax-free to you as the pension holder, any unused lump sum allowance upon your death can be taxed at the beneficiary's marginal rate; this is further detailed in the section below
  • Most defined contribution pensions let you take your lump sum from age 55, but some workplace schemes may have their own specific rules
In summary, the 25% lump sum rule gives you early access to a portion of your pension tax-free, while leaving the remaining amount still invested for retirement. Each pension pot you have entitles you to a separate 25% lump sum allowance.
In summary, the 25% lump sum rule gives you early access to a portion of your pension tax-free, while leaving the remaining amount still invested for retirement. Each pension pot you have entitles you to a separate 25% lump sum allowance.
What are the tax rules for pension beneficiaries?
Declaring a beneficiary for your pension can be a smart way of leaving money to a loved one in a way that avoids them being harshly taxed. Taxation rules differ depending on the pension scheme you have and your age when you die:
  • Before turning 75 – if you die before age 75 and are yet to withdraw any funds from your pension, your beneficiaries can claim your entire pension pot tax free. They have two years to claim the pension. If you die before age 75 and have begun withdrawing from your pension, your beneficiaries may still be able to access your pension funds as a tax-free lump sum. They may also be able to withdraw regular payments.
  • After turning 75 – if you die after you have tuned 75 your beneficiaries will have to pay income tax at their marginal income tax rate.
In summary, taxation rules for beneficiaries depend on several different factors such as the pension scheme you have, the provider you are with, and the age you are when you die. Therefore, it is important to consult with your particular pension provider on what their rules are. It can be helpful to consult with a regulated financial adviser to ensure that you have all the relevant information regarding your particular pension scheme.
How is the pension lump sum amount calculated?
The maximum lump sum you can take is 25% of your total pension savings within an individual pension pot. But how is that 25% figure calculated exactly?

For defined contribution pensions, including most personal and workplace pensions, the calculation is fairly straightforward:
  • Your pension provider will calculate 25% of the total current value of each of your pension pots
  • After turning 75 – if you die after you have tuned 75 your beneficiaries will have to pay income tax at their marginal income tax rate.
For example, if you have 3 defined contribution pension pots as follows:
Pot A value:
£50,000
Pot B value:
£80,000
Pot C value:
£120,000
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
  • 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.
  • 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.
  • 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
  • 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.
  • 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.
  • 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.
  • 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:
  • The full 25% tax-free lump sum of £20,000
  • A smaller tax-free lump sum of say £10,000 (12.5% of your fund)
  • 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:
  • You take the lump sum while still earning other taxable income from a job
  • Your total income for the year exceeds the higher or additional rate tax thresholds
  • 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*:
  • John is about to retire
  • He’s been a member of his employer’s final salary pension scheme for 40 years
  • The scheme’s accrual rate for building up his pension is 1/80th for each year’s membership
  • John’s final pensionable earnings are £30,000 a year
  • 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:
  • 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.
  • A regulated financial adviser can make you aware of options for managing tax liability if you have several pension schemes.
  • 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.
  • 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.
  • 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.
  • 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.
  • 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
So in summary, if you have a personal pension or a defined contribution workplace pension, you can cash it in from age 55, provided your scheme offers flexible access. You can check with your provider to confirm.

In summary
A tax-free lump sum from your pension can provide very useful flexibility and options for accessing retirement savings early. But there are rules, risks, and tax implications to take into account.

For most people, getting regulated financial advice is essential to ensure you fully understand how taking a lump sum could impact your current and future finances.

The right advice can help you take advantage of the opportunities pension lump sums provide, while avoiding potential pitfalls and penalties.
The details provided in this article are for general information only and are in no way deemed to be financial advice. All of the material is correct as of the publication date, but could be out-of-date by the time you read the article.
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