What you need to think about before taking a tax-free pension lump sum

We are still several weeks away from the autumn budget, but speculation is swirling that tax-free pension cash could be cut. This is a rumour that risks people making decisions they later come to regret.

While the main purpose of a pension is to give you an income throughout your retirement, you can take out lump sums whenever you want from the age of 55. Up to 25% of the total value of your pension can be withdrawn tax-free.

Rumours that this allowance could be cut has already had an impact – in the most recent FCA Retirement Income Market stats, the number of plans entering drawdown where only tax-free cash was taken surged by 29% between 2023-24 and 2024-25. The amount of tax-free cash taken overall ballooned by 63%. It suggests that people could be making big decisions in haste that they could repent at leisure.

Read more: Why relying on inheritance for retirement is a bad idea and what you could do instead

The decision to take tax-free cash should be part of a long-term plan made after assessing all the pros and cons rather than a knee-jerk reaction in response to a rumour that could have a whole host of unintended consequences.

Three things to think aboutThe decision to take tax-free cash should be part of a long-term plan made after assessing all the pros and cons.·Abraham Gonzalez Fernandez via Getty Images

1. Don’t take it because you can – have a plan!

Many people take their tax-free cash as part of a long-term plan to pay off their mortgage, travel or make home renovations.

If you take it without knowing what you want to do with it, then you risk some poor outcomes. One example would be taking the money from a really tax efficient environment within a self-invested personal pension (SIPP) and keeping it in an account paying poor rates of interest while you decide what to do with it. There’s also the potential to fritter it away over time.

2. What are the tax consequences?

You need to consider the tax consequences of where you plan to put this tax-free cash. You could reinvest some in a stocks and shares ISA but if you’ve got a significant amount, you may still have money left over. Depending on what you want to do with it you need to consider the potential impact of taxes such as capital gains tax or dividend tax.

3. Are you planning to reinvest it back into your SIPP if the decision doesn’t happen?

You may decide to take the money now and if the decision doesn’t happen simply reinvest it back into your SIPP. This may seem straightforward, but you need to beware that you don’t fall foul of pension recycling rules.

Read more: The state pension is set to rise — here's how much it could go up by next April

This is where an individual is deemed to have taken tax-free cash and reinvested it into their pension to benefit from significantly increased tax relief.

Story Continues

Breaching these rules could land you with a nasty tax charge with HMRC looking at issues such as how much was taken, the proportion of tax-free cash contributed, whether there has been a significant uplift in contributions as well as member intent.

Getting this wrong could derail your long-term plans so if you are looking to do this you should seek financial advice. It’s also worth noting that HMRC has clarified its stance around cancellation rights. This means you are unlikely to be able to request tax free cash and then cancel the instruction if there’s no change in the budget.

Read more:

Why lifelong housing costs are derailing retirement planning for older people What to consider when writing a will Why taxes will rise after the budget, and how to protect yourself

Download the Yahoo Finance app, available for Apple and Android.

View Comments