Tax-free lump sum pension: a guide

As you approach your retirement, it’s natural that you might want to start making cash withdrawals from your pension. The good news is that many pension schemes allow you to take a portion of your pension as a tax-free lump sum, meaning the money won’t count as taxable income.

On this page, you’ll learn everything you need to know about tax-free pension lump sums, how you could get one and what you might want to consider. We also highlight some of the other ways you might be able to increase your retirement income, such as by opening a competitive savings account.

A pension lump sum is a certain amount of your pension you can withdraw tax-free, typically in one go. The tax-free benefit provided by the government is usually up to 25%.

The rules for taking a lump sum out of your pension pot depend on the type of pension scheme you’re in. If you’re in a defined contribution pension scheme, you can take up to 25% of the pension pot tax-free (and a maximum amount of £268,275) with the remaining amount subject to income tax according to your tax band. In a defined benefit pension scheme, HMRC defines the maximum amount you can withdraw.

You usually withdraw your tax-free pension lump sum after the age of 55 (although this will rise to 57 from 2028). If you want to withdraw a lump sum before then, you may have to pay a large amount of tax, typically around 55%.

There are some circumstances in which you might be able to withdraw your pension lump sum before you’re 55. These circumstances include having certain health conditions, or an occupation that traditionally means you’ll retire at an early age, such as being a professional athlete.

It’s also important to be aware of pension scams. It’s been known for some pension providers to promise early pension access with high fees reaching up to 30%. Meanwhile, your remaining funds might go into high-risk investments.

A defined contribution pension is usually a personal or workplace pension, where you build up your pension pot through contributions made by you and your employer. With this type of pension, you can usually take up to a 25% tax-free lump sum (up to a maximum amount of £268,275). The availability of this option usually means that the scheme you’re in has crystallised and you need to decide what you want to do with the rest of your pension pot. Usually, the following options will become available:

• Keep investing in an income drawdown plan
• Purchase an annuity, which provides a guaranteed fixed income
• Cash in your entire pension pot, which will be taxed

Crystallised lump sums mean that your pension provider will give you the option to decide on what you’ll do with the 75% that remains in your pension pot. Uncrystallised pensions just mean that your pension pot hasn’t been turned into a source of income yet.

Uncrystallised pensions are similar to savings accounts, in that you can take out cash when you need to, while your pot continues to grow. Each withdrawal you make from an uncrystallised pension pot is 25% tax-free. The remaining 75% in that same withdrawal will be taxed as income.

No matter what size your pension pot is, you have the option to take all of it, or a portion of it, out in one go as a lump sum. With 25% of your total pension being tax-free, the amount of your pension lump sum you’ll have to declare to HMRC depends on how much you withdraw.

For example, if you have £80,000 in your pension pot and decide to take it all out as a lump sum, only £20,000 will be tax-free. You’ll have to declare the remaining £60,000 as income and pay the relevant taxes. If, however, you prefer to take a £2,000 lump sum from your pension pot every month, you’ll instead pay tax on £1,500, while the leftover £500 will remain tax-free.

After the 25% tax-free amount, all of your pension pot is taxable, and you will need to declare it as income. Whatever the amount is, it’ll be added to your total annual earnings so that you’re taxed correctly. If you’ve retired and are receiving your state pension, your tax band will depend on how much you’re withdrawing from your pension. If you’re working and receiving a taxable pension, combining the two amounts to determine your total income could push you into a higher tax band.

Not all pension providers will offer you the choice of making small sum withdrawals from your pension pot. Some pension providers may limit you to making withdrawals once or twice a year, and may also apply fees if you make more frequent withdrawals within a set period.

If you’re looking to make lump sum withdrawals from your pension pot, you may want to consider whether you’ll have enough money to last throughout your retirement. If your pension is your only source of income, other strategies might prolong your pension income, including the following:

1. Deferring your state pension: This may sound counterproductive, but delaying your state pension claim actually increases its value over time. You can defer your claim at any point and for however long. If you receive the new state pension, applicable from the 6th April 2016 onwards, your pension will increase by 1% for every nine weeks you defer it. If you receive the basic state pension, applicable before the 6th April 2016, you’ll receive a 1% pension boost for every five weeks you defer.
2. Voluntary NI contributions: If you’ve missed any National Insurance contributions, this will mean that you won’t be eligible to receive the full state pension, which requires you to have made 10 years of NI contributions. Luckily, you’re able to pay voluntary National Insurance contributions to make up for any missed payments. As you’re exchanging your contributions for additional state pension years, you’re eligible for pension top-ups.
3. Buying an annuity: To ensure you get a regular income once you retire, you can use a portion of your pension pot to buy an annuity. Annuities are in place to give disadvantaged individuals guaranteed financial support for the rest of their life, which can be particularly useful if you have a medical condition or reduced life expectancy. In these cases, you can apply for an enhanced or impaired life annuity, which usually offers incomes between 20% and 50% higher than basic annuities.

In addition to these strategies, you can also ensure you’ve claimed your tax relief, consider pension drawdowns or use the government’s free service to look for any lost pensions.

If you’re retired and are on a low income, you may also be eligible to claim Pension Credit. Pension Credit is a means-tested benefit scheme that can either top-up your weekly income if it falls below a certain amount, or supplement your income with extra payments, depending on your circumstances.

The amount of tax you’ll need to pay on a lump sum will depend on the income tax band you’re in. The money you take from your pot comes from your pension provider, who will automatically deduct tax. Your pension provider may also take off any tax due on your state pension.

The amount of tax applied to your pension depends on how you want to withdraw your pension. If you want to withdraw it all in one go, 25% of the total amount will be tax-free, meaning you’ll pay tax on the remaining 75%. (The only exception to this is if you’re aged under 75 and are diagnosed with a terminal illness that means you aren’t expected to live for more than a year. In these circumstances, you may be able to withdraw your entire pension as a tax-free lump sum.)

You may also have the option to withdraw your pension in small sums, in which case 25% of each withdrawal would be tax-free. For example, if your pension pot is £50,000 and you want to withdraw £2,000, you’ll get £500 tax-free, and the remaining £1,500 will be taxable income.

If you want to increase your retirement income to have a more comfortable lifestyle, you might want to consider continuing to work on a part-time basis. You’ll still be able to enjoy some extra free time but the additional income can help to preserve your pension pot, meaning you’ll have more money to draw on later on.

You might also want to think about opening a high-interest savings account. If you’re happy to lock your money away for a set period, fixed rate bonds can provide a competitive, fixed interest rate and help you save more for your retirement. They’re also ideal if you want to grow your retirement savings without the usual risks that other investment options such as stocks and shares may come with.