Taking up to 25% tax-free cash from a pension – what you need to know

The chance to take tax free cash from your pension is one of the most popular perks of saving into a pension. Usually up to 25% can be paid to you tax free.

But there are lots of misconceptions around how and when to take your tax-free cash. It’s time to set the record straight.

This article isn’t personal advice. Pension and tax rules can change and any benefits will depend on your circumstances. To find out more about the type of pension you hold and the options available to you, you should look for free and impartial guidance from Pension Wise, or if you’d like personal advice on what’s best for your situation you should ask for financial advice.

Can I take 25% tax-free cash from all my pensions?

Broadly speaking yes.

If you have a defined contribution (DC) pension, like the HL SIPP, you can usually receive up to 25% completely tax free. Even if you have a number of DC pensions with different providers, you can still usually take up to 25% of each pot tax- free.

If you have more than one DC pension, you might want to consider bringing them together into one easy to manage account. This could help to give you a clearer view of how much you’ve saved and what you’re on track to get at retirement, as well as how much tax-free cash you could be entitled to. Before transferring a pension you should always check if you will be charged excessive exit fees and whether you’d lose any valuable benefits.

More on the benefits of consolidating old pensions

If you have a defined benefit (DB) pension, like a final salary pension, you can take up to 25% as tax free-cash but your scheme might require you to give up some of your income for this. The way in which the tax-free cash is calculated can mean you sometimes get less than 25%, but your taxable income will be secure.

Do I have to take my tax-free cash in one go?

A common misconception around tax-free cash is that you have to take it all in one go. In fact if you have a defined contribution pension, there are actually two options, which means you can take your tax-free cash in stages. They include:

1. Lump sum payments (UFPLS)

   By taking a lump sum from your pension, up to 25% will be paid to you tax free and the rest taxed as income.

   For example, let’s say you made a £10,000 pension withdrawal as an UFPLS, 25% (£2,500) would be tax-free, the rest (£7,500) would be taxed as income. Then at a later date you could choose to take another UFPLS from your pension, and you’d be entitled to 25% tax-free again. You could repeat this as many times as you want until your pension is gone or until you use up your Lifetime Allowance, currently £1,073,100.

   If you choose this option, be aware that you’ll trigger the Money Purchase Annual Allowance (MPAA). This means your future money purchase pension contributions will be limited to £4,000 a year. So if you plan to continue or resume paying more than this into a pension (which includes payments made by your employer) after accessing your pension, you might think this isn’t the best option for you.

2. Partial drawdown

   This involves only moving a portion of your pension into drawdown at a time. And of the portion you move into drawdown, you’ll receive 25% as a tax free lump sum payment.

   Let’s say you had a pension pot worth £100,000, you could decide to only move £10,000 into drawdown and take up to £2,500 (25%) as tax-free cash lump sum. The rest of that portion (£7,500) is moved into a drawdown account until you decided to take a taxable income. Remember though, this will trigger the MPAA, like we explained earlier on. The remaining £90,000 would be untouched in your pension and continue to have the potential for future growth – and a higher tax free cash value.

   To find out more about the ways to take money from your pension, including how to take up to 25% tax free and swap the rest for an annuity (secure income), download our guide.

   Download guide

Should I take my tax-free cash as soon as I can?

From age 55 (rising to 57 by 2028), you can access your pension. But just because you can, doesn’t necessarily mean it’s a good idea – especially during the current climate.

You should only take what you need- remember you don’t have you take the full 25% from a defined contribution pot in one go.

If the value of your pension has dropped over the past couple of months, you might want to hold off accessing your pension if you can. Other easy-to-access savings might be a better option if you need short-term support during the pandemic.

If you choose to take your tax-free cash now, you could be choosing to sell investments in your pension at a low price to make that cash available. That means you’d have sacrificed a potentially higher future tax-free cash value.

By choosing to keep your pension invested, it might give you extra time for the markets to hopefully recover, so you can make the most of your tax-free cash entitlement. Of course this isn’t guaranteed, markets, and the value of your pension, could fall further in future. Unlike the security offered by cash, all investments fall as well as rise in value, so you could get back less than you invest.

What could I do with my tax-free cash?

People usually have plans for some of their tax-free cash. You might want to use some of it to pay off your mortgage or to help get your children on the property ladder. But it’s important to think about what you’ll do with the rest. Inflation reduces the spending power of cash so just leaving it in your current account might be a mistake.

As rule of thumb though, you should hold enough cash to cover three to six months’ worth of expenses. This goes up to one to three years’ worth of expenses when you’ve finished work altogether as it’ll be harder to replenish your cash buffer.

In addition, any planned expenses in the next five years that can’t be covered by income should be held as cash. For example, if you’re planning to do work on your house. As mentioned, it’s usually a good plan to only take the amount of tax free cash that you need at the time. Not only could you end up with a higher tax free cash value, it’s got a chance to grow tax free and any money left in your pension will usually fall outside of your estate for inheritance tax purposes

Getting a better return on your cash

If you're looking for ways to make the most out of your cash outside a pension you could consider fixed term saving products, like those available through our online Active Savings service. They could potentially give you a higher rate of interest than instant access saving accounts from a big high street bank and peace of mind that both your capital and future returns are guaranteed. But you need to be happy for your money to be tied up until maturity. This can be anywhere from one month to three years or more. Our Active Savings service also offers easy access options for any cash you’re not happy to tie in.

More on active savings