Should you take a tax-free lump sum from your pension?

Your 55th birthday, rising to 57 in 2028, often marks being able to access your pension for the first time. The opportunity to take a 25% lump sum tax-free is certainly attractive and can be too tempting to resist. But it’s not a decision to take lightly and it isn’t the right move for everyone.

The ability to take a tax-free lump sum means that pension savings are becoming disconnected from retirement, research suggests. For many of us, retirement is still some way off at 55 and you may plan to work for many more years. Removing a quarter of your savings before you give up work could affect your long-term income.

Deciding when and how to access your pension is important. Despite this, a survey from PensionBee indicates thousands of over-55s aren’t fully considering the impact early withdrawals will make. In fact, almost half (48%) hadn’t considered how they’d manage throughout retirement.

So, what should you think about before you withdraw that lump sum?

1. Why do you want to take a lump sum from your pension?

According to the survey, just 3% of those considering accessing their pension did so because they were retiring or stopping work. A further 17% would use the money to cover day-to-day expenses and 9% would spend it on something special.

If those thinking about accessing their pensions aren’t planning to spend the money, why are they taking this step? Three popular responses suggest that for some, the reasons don’t align with financial goals.  

• 32% worry about pensions falling in value

• 20% would make a withdrawal so they would have more ‘control’

• 12% said they simply felt a pressure to do something with it

What’s the issue with these responses?

First, pensions are typically invested, and you should expect some short-term volatility. If you’re worried about your pension losing value, it’s important to focus on the long term. If you don’t plan to use your pension as an income for several years, leaving it invested is likely to be most appropriate. It’s also worth noting that if you choose to take a flexible income from your pension, the money you don’t withdraw will usually remain invested. Speak to us if you have concerns about pension investments and market movements.

Second, you do have control over your pension investments. With a typical Defined Contribution pension, you’re usually able to choose from several different investment funds to match your risk profile and goals. This is suitable for most pension savers. For some, a Self-Invested Personal Pension (SIPP) is an option to explore but this can be complex and you must be comfortable managing investments, we’re here to provide guidance where needed.

Finally, don’t feel under any pressure to make pension withdrawals just because you’ve turned 55. For most people, if you’re not retiring, it makes sense to leave savings invested through a pension and continue adding to it.

2. What will you do with your tax-free lump sum?

The figures above established that relatively few people considering accessing their pension to withdraw a lump sum intend to spend the money. If you do plan to spend, you need to consider the long-term consequences first, which we’ll look at in the next point.

However, if you don’t plan to spend the money, what are your options?

Placing the money in a savings account: Some responders indicated they intended to withdraw money to place it into a cash savings account. If you’re nervous about pension values falling or want retirement savings to seem more tangible, this may be viewed as a ‘safe’ option. After all, market movements won’t affect the lump sum withdrawn.

But inflation will affect savings. Interest rates are low at the moment and while values won’t fall because of investment performance, the value will decrease in real terms. That means over time your savings will buy less due to inflation.

Investing the money: If you’re thinking about taking money out of your pension to invest it, remember your pension is likely already invested. Pensions are a tax-efficient way to save for retirement. Leaving your money invested in a pension and adding to it until retirement makes financial sense for most people. It’s worth taking the time to understand how your pension savings are currently invested, the associated costs, and the long-term investment performance before you make any decisions.

3. What impact will it have on your retirement plans?

Over a third (35%) of people said they didn’t know how to find out how much they could expect to receive from their pension in retirement.

Before you make plans to make any withdrawals, it’s essential you understand the value of your pension and how this will translate to an income. If you took the maximum 25% tax-free lump sum from your pension, that’s a sizeable amount. Doing it while you’re still in your 50s, with retirement perhaps several years away, means you’re missing out on the investment growth of this sum too.

Making a pension withdrawal as soon as it becomes an option could mean your income is far lower during retirement. Would you still take a lump sum to spend now if it meant the 30 years you spend in retirement are less comfortable?

The key here is to understand what impact taking the tax-free lump sum would have. We’re here to provide insight. We’ll help you to see what income your pension will provide if you take a lump sum now, taking it further down the line, or not taking it all, taking your retirement goals and plans into consideration.

4. Will it affect your Inheritance Tax liability?

The standard Inheritance Tax rate is 40% and can significantly reduce the amount you leave behind for loved ones. If your entire estate is worth more than £325,000, you should review whether the assets you leave behind will be liable for Inheritance Tax and the steps you can take to reduce the bill.

But what does this have to do with your pension? Well, if you withdraw money from your pension, this money will become part of your estate for Inheritance Tax purposes and, therefore, may increase liability.

While a pension does form part of your estate, savings held in a pension are efficient for Inheritance Tax purposes. If you were to pass away before you turned 75, no tax would usually be due on your pension savings. If you pass away after you’re 75, the money you leave behind will liable for Income Tax, which, in many cases, will be lower than the Inheritance Tax rate. As a result, leaving money in your pension can make financial sense for you and your loved ones.

Make sure you complete an expression of wishes with each pension provider stating who you’d like to benefit from your pension savings when you pass away.

If you’re able to take a tax-free lump sum out of your pension and want to understand your options, please get in touch. We’ll help you see how removing a lump sum from your pension now will affect your income in retirement and how to make the most of any withdrawals. 

Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Your pension income could also be affected by the interest rates at the time you take your benefits.

Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.

The Financial Conduct Authority does not regulate tax or estate planning.