Understanding the pension tax-free lump sum

You can take 25% of your pension pot without paying income tax through a lump sum. The rest can be converted to an annuity, used for pension drawdown or simply be left untouched.

Ruth Jackson-Kirby Published on 24 March 2021. Last updated on 25 March 2021.
Understanding the pension tax-free lump sum

You can take as much as 25% of your pension savings as a tax-free lump sum, which if you can afford it, can help fund any large expenses that you might have at this stage of life.

Here’s what you need to know about getting your hands on that tax-free cash.

What is a pension tax-free lump sum?

When you take money from your pension most of it will be taxed at your income tax rate. However, you can take up to 25% of it tax-free in what is known as the Pension Commencement Lump Sum (PCLS).

The rules surrounding your personal lump sum will depend on the type of pension you have and your pension provider. Typically, if you have a defined contribution pension you can take up to 25% of it tax-free once you turn 55.

Generally, you don’t have to take your entire PCLS as one lump sum. You can take it as a series of smaller sums until you hit your 25% limit. However, your PCLS – or tax-free cash – can only be taken at the point of ‘crystallisation’ where your pension is accessed in order to provide retirement benefits, for example, going into drawdown or purchasing an annuity.

If you aren’t ready to do this but still want access to cash lump sums you can do so using so-called ‘uncrystallised pension fund lump sum’ rules. Here you can make cash withdrawals whenever you need the money and leave your remaining funds untouched in your pension. The difference is that only the first 25% of each withdrawal is paid tax-free and the remainder is subject to tax at your personal rate.

If you have a defined benefit pension, or final salary pension, the rules are set by your pension provider and you will need to contact them to find out how much you can withdraw as a PCLS.

» COMPARE: Personal pension providers

Why might I take out a tax-free lump sum from my pension?

There are any number of good reasons to take your tax-free lump sum out of your pension, there are also some terrible ones. Remember though that just because you can take your PCLS from the age of 55 doesn’t mean you have to. You can leave your pension to grow and take that lump sum at a later date or just leave it untouched and use the money to boost your retirement income instead.

There are plenty of reasons to take a tax-free lump sum such as clearing the last of your mortgage or other debts in order to reduce your outgoings in retirement. You may need a new car or want to do work on your home.

However, there is one popular reason why some people take the tax-free lump sum. A survey by financial services provider Aegon back in 2017 found that 32% of people who took their PCLS simply put it into a cash ISA or savings account. It's worth remembering that interest rates on cash savings are low right now and your money may not grow at all in real terms, nevermind at anything close to the growth it may have been enjoying while it was invested in your pension.

» MORE: How to plan your retirement

How can I access a tax-free lump sum?

If you want to take a tax-free lump sum from your pension you should speak to your pension provider to ask if you have the option to take a tax-free lump sum.

If they don’t you could consider transferring your pension to another provider. Read our guide to pension transfers to find out more.

Check with your provider what fees and charges you may pay to access your lump sum and ask them about the process.

Remember, you must be over 55 in order to access your pension. Take money from your pot before then and you could face a 55% tax charge on top of penalty fees from your pension provider. If you are contacted by anyone saying they can help you access your pension early it is likely to be a pension scam.

Pros and cons of taking a tax-free lump sum

There is a lot to consider before you start taking money out of your pension – even if it is tax-free.

The benefits of taking a tax-free lump sum are:

  • You are free to choose what you do with your money.
  • You can pay off any outstanding debts you might have like your mortgage.
  • You can raise the funds for larger expenses like home improvements or a new car.
  • You can reduce your pension’s exposure to investment risk.

The drawbacks of taking your tax-free lump sum are:

  • You reduce the size of your total pension and run the risk of running out of money in retirement.
  • Taking money out of your pot reduces the level of income the remaining capital can generate.
  • You miss out on further investment growth on that money.
  • Your money remains sheltered from inheritance tax while it is in your pension.

Where can I go for pension advice?

Everyone aged over 50 with a pension is entitled to a free pension consultation with the government’s Pension Wise service. However, this only provides basic guidance, for comprehensive advice based on your own personal circumstances you will need to consult an Independent Financial Adviser. You can find an IFA at Unbiased or via the Personal Finance Society.

» MORE: How to get pension advice

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About the author:

Ruth is a freelance journalist with 15 years of experience writing for national newspapers, magazines and websites. Specialising in savings, investments, pensions and property. Read more

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