As you approach retirement, your thoughts may turn to the best ways to use those pension savings you’ve been squirrelling away. And if you’ve got debts to pay, or big purchases you’ve been holding off on, the idea of getting your hands on a chunky pension lump sum may be alluring.
The good news is that you should be able to dip into part of your pension pot tax-free. Read on to find out more about the rules around taking a tax-free pension lump sum, and the trade-offs you could be making by doing so.
At the age of 55 (rising to 57 from 2028), you can start to take money out of your personal or workplace pensions. Most of the money you take out is subject to income tax, but there’s an exception: the pension tax-free “lump sum”.
It’s a chunk of your pension that you take out completely tax-free when you reach pension access age (or at any point thereafter) – 25% of your pension value, to be specific. You can use it however you like.
Assuming your lump sum doesn’t exceed 25% of the value of your pension pot, you’ll pay nothing, nada, zero, zip. Even if, in the year you take out your pension lump sum, you also have lots of income from employment, your 25% lump sum is exempt from tax.
If you decide to take out a bigger lump sum, you’ll be liable for income tax on anything above 25%. How much, if any, income tax you have to pay will depend on how much extra you withdraw from your pension, plus your other taxable income in the same year.
Once you’ve used up the tax-free 25% of your pension pot, anything above this will be subject to income tax. The same rules apply to this pension income as to any other income.
This means that taxable pension income will be combined with taxable income from other sources, such as employment. You’ll pay tax at the standard UK tax rates. We’ve summarised these in the table below for the 2022–23 tax year.
Importantly, the first £12,570 of potentially taxable income is covered by your personal allowance, for which the tax rate is 0%. This means that if you earn no other taxable income, you can receive up to £12,570 of pension income per year without paying income tax. That’s in addition to your 25% tax-free lump sum.
It’s worth bearing in mind that when you first take money from a pension above the tax-free lump sum, there’s a risk that HMRC might get your tax codes wrong to start with. It’s most likely to happen if the first amount you take out is bigger than you plan to take in subsequent months. This could result in overpaid pension tax initially, though you’ll get it back in due course.
| Annual taxable income | Tax band | Tax rate |
|---|---|---|
| Up to £12,570 | Personal allowance | 0% |
| £12,571 to £50,270 | Basic rate | 20% |
| £50,271 to £125,140 | Higher rate | 40% |
| More than £125,140 | Additional rate | 45% |
Note: The tax bands and rates in Scotland are slightly different to the rest of the UK. You can see the standard rates on the Scottish Government website.
Alex has just turned 55 and earns an annual salary of £30,000. Now that she’s able to access her pension, she is keen to use it to pay off her outstanding £40,000 mortgage debt.
To help with this, she decides to take a £45,000 lump sum out of a personal pension worth a total of £100,000.
Here’s how her income tax for the 2024/25 tax year will be calculated.
Alex’s total taxable income is below the higher-rate tax threshold. This means she’s liable to pay basic-rate income tax on her taxable income above her personal allowance.
Her total income tax bill for the 2023/25 tax year will be £7,486, leaving her with a total income of £67,514. However, because she hasn’t reached state pension age, she’d also have to pay national insurance (NI).
* This is a fictional, but realistic, example.
Absolutely. Each pension scheme you hold should let you take a 25% tax-free lump sum. And you don’t have to take lump sums from all your pots at the same time, either. If you have 2 separate pension pots, for example, you could take 25% from the first when you reach age 55, and leave the other pot untouched until a few years later.
This would give the money in the second pot a chance to grow further (from additional contributions and, hopefully, investment growth). That means the 25% lump sum you get from the second pot could be worth more when you eventually took it.
So far so (relatively) simple. And if you only have defined contribution pensions, whether they’re personal or workplace schemes, it usually is that simple. You can take 25% of the value of each pension as a tax-free lump sum. You can leave the rest of each pot invested for as long as you like. When you do take more money out, you’ll pay tax on it.
This applies whether you take it in one go, through pension drawdown or by buying an annuity. You can read more about your options in our full guide to defined contribution pensions.
It gets a little more complicated if you have a defined benefit pension, such as a final salary or career average pension.
With defined contribution pensions, you have a pot of a certain value to choose what to do with. With defined benefit pensions, you’re instead paid a regular income based on a proportion of your salary while you were working for a company.
The amount of income you receive each year is set in advance, regardless of how long you live. This means it’s harder to put a total value on your pension pot, and work out what 25% of it equates to.
While many (though not all) defined benefit pension providers still let you take a lump sum, they need to work out how much you’re entitled to differently. To do this, many schemes use something called a “commutation factor”. This is the amount of tax-free lump sum that will be paid per £1 of pension income given up. There is likely to be a maximum cap on this. The higher the commutation factor, the better the deal you’ll usually get.
Some schemes work out any tax-free lump sum entitlement differently. But, regardless of how it’s calculated, taking a tax-free lump sum is likely to reduce your annual defined benefit pension income.
Ask whoever is in charge of the pension how any tax-free lump sum is calculated, and what impact it will have on your annual income. If you need help working out whether it’s a worthwhile trade-off, it could be worth speaking to a regulated financial adviser.
Okay, so we said that taking a lump sum from a defined contribution pension is pretty simple. And usually, it is – with one small caveat.
That’s because there are actually 2 ways in which you can take your 25% tax-free lump sum from a defined contribution pension scheme. You can either:
Not every provider offers UFPLS, but if yours does, the best option for you will depend on your circumstances and the size of your pot. If you’re undecided, it’s worth speaking to a Pension Wise adviser. Pension Wise is a government service that offers free guidance about your pension options, to help you decide what’s best for you. You can book a free appointment from the age of 50.
Whether or not a pension lump sum is classed as income (it is) is less important than whether the income is subject to income tax.
The key thing is that the first 25% of the value of a pension is income-tax-free, while anything above this is subject to income tax. That applies whether you take the remainder as a lump sum or as regular monthly income.
How long is a piece of string? There are advantages and disadvantages to both, and it doesn’t have to be a black and white decision. Many people may choose to take their tax-free lump sum up-front, for example to pay off outstanding debts (such as a mortgage) or cover large expenses (such as a new car), and use the rest to provide a regular income.
Of course, it’s worth bearing in mind that taking even tax-free money out of your pension as early as you can (currently at age 55) will reduce the size of your total pension pot and the chance that money would otherwise have had to grow over another few years. But the upsides may outweigh these disadvantages for you.
You don’t need to declare any 25% tax-free pension lump sum on your tax return. But if you complete one, any other money you take from your pension should be declared.
Not everyone needs to complete a tax return, though. If your affairs are fairly simple – say you receive the State Pension and income from 1 or 2 personal or workplace pensions – in most cases your tax will be taken by one of your pension providers.
HMRC will usually contact you to let you know if you need to complete a tax return. If you think your tax is being taken incorrectly, you should contact HMRC directly.
"Using your 25% tax-free lump sum when you reach 55 can be useful, but you need to be strategic about your plans.
For example, that money could be most useful when you’re having to pay tax elsewhere or you need to access a lump sum in a tax-efficient way. If you don’t need to use these funds straight away, it might be worth leaving your pension grow for a few more years because if it does, you should be able to access an even bigger tax-free lump sum (or payment instalments) if your overall pot is worth more.
It’s also worth remembering there are other ways to avoid paying income tax on investments. If you also save into a stocks and shares ISA along with a pension, using the two accounts in tandem can help minimise your tax obligations."
It may feel like a no-brainer to take out your tax-free pension lump sum as soon as you can. But as with any big financial decision, it’s worth taking a bit of time to consider your options and work out what’s best in the long-run.
Depending on your specific circumstances, there may be good reasons to delay taking your 25% tax-free lump sum, or even not to take it at all. Make sure you take advantage of your free Pension Wise appointment to get expert guidance on your options, or if you want more personalised advice, speak to a regulated financial adviser.
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