What you need to know about pension lump sum withdrawals and tax-free cash

You can take as many lump sum withdrawals from your pension as you wish from the age of 55 (increasing to age 57 from 6 April 2028). Ex-Pensions Minister Steve Webb famously hinted at the possibility of withdrawing your entire pension pot to purchase a Lamborghini and although most people are not quite so frivolous, it is important to remember that your pension is designed to provide an income for your whole retirement and if you withdraw too much too soon, you could run out of money in later life or be faced with a significant tax bill. In this article, we discuss important considerations surrounding withdrawing money from your pension in this way.

Bertrand Pole
Published: 01 Dec 2021 Updated: 21 Jun 2022

What is pension tax-free cash?

When drawing out a lump sum from your pension, you have the choice to draw up to 25% of it tax-free, subject to you having a sufficient amount of lifetime allowance remaining. You can choose to draw just the tax-free element and leave the remaining amount in a drawdown pension. The tax-free cash can be taken in one withdrawal, or can be split into smaller lump sums, paid out over a number of years.

What are the benefits of taking a pension lump sum withdrawal?

Making a lump sum withdrawal from a pension is a popular option due to the tax-free cash element. People use this money for a number of reasons, including providing a financial kick-start to their retirement, yet they also want to make sure that their money will last. It’s a good idea to speak to an expert so that you can see exactly how much you have, how much you will need in the future and how much you can afford to take now.

Withdrawing your pension tax-free cash is also an extremely useful option for people who are over the age of 55 but are still working and making pension contributions. If you are in this position, it is very important that you only take out your tax-free cash as otherwise, you could trigger the money purchase annual allowance, which will reduce your pension annual allowance to £4,000.

During the Covid-related lockdowns of 2020 and 2021, many people sought ways to boost their income and unfortunately, did not take professional financial advice before doing so. A large number of them accessed their pension whilst still in paid employment. They did not realise that they had the option to take tax-free cash and instead took an uncrystallised funds pension lump sum, triggering the money purchase annual allowance. As a result, many people who still have years before they retire and are a member of their company’s defined contribution scheme, will be limited to the £4,000 annual allowance. The annual allowance remains at £40,000 for people with defined benefit pension schemes (also known as a final salary pension).

Additionally, if you are still working and take a taxable income from your pension rather than just the tax-free cash, you could end up moving yourself into a higher-rate tax band. For example, if you earn £45,000 a year from paid employment, you’re just within the basic-rate band threshold. If you start taking pension income, you’ll immediately start paying higher-rate tax, but if you just take the tax-free cash lump sum, your tax band will stay within the basic limit.

Are there any drawbacks to taking a pension lump sum withdrawal?

One of the biggest problems with making a large lump sum withdrawal from your pension is that without careful planning, you could be faced with a significant tax bill. If you take smaller withdrawals over several years instead, you can keep the withdrawals within your basic rate tax band and if they are less than £100,000, you won’t lose your personal tax allowance.

The other potential issue with taking a pension lump sum withdrawal is that you could run out of money in later life. If you are relying on your pension to fund your retirement, you need to make sure that there is still enough money left after making the withdrawal. You also need to factor in other costs, such as long-term care, and the impact of inflation. One of the best ways to see how much you can afford to take is through the use of cashflow modelling.

Although having the option to take a lump sum from your pension is extremely useful, the reality is that you should only take out exactly what you need and leave the rest where it is. Some people decide to take a large lump sum because they are concerned that the rules surrounding pension withdrawals and tax-free cash are going to change, but this is not necessarily the best option. By leaving as much money in your pension as you can, it grows in a tax-efficient environment. There is no Capital Gains Tax or Income Tax payable on pension assets. If you die before you have exhausted your pension investments, you can pass them on free of Inheritance Tax too. It is, however, important to remember that by leaving your money invested, its value can go down as well as up.

How do lump sum withdrawals affect my pension?

Every time that you take a lump sum from your pension, you use up a proportion of your pension lifetime allowance of £1.0731 million. As with many pension calculations, this isn’t always the most straightforward process, so it’s usually a good idea to speak to an expert. They can then help you to work out exactly how much of your pension lifetime allowance you have used for your withdrawal.

Can I take tax-free cash from my pension after 75?

If your pension provider allows it and you have sufficient tax-free cash available, then tax-free cash can still be taken from your pension after the age of 75. Calculating how much tax-free cash you have available after this age is linked to the lifetime allowance test carried out at the age of 75. Any amount you have in income drawdown is tested first. Then, if there is any lifetime allowance remaining, the uncrystallised funds are tested. Any amount which is within the lifetime allowance then becomes known as ‘unused funds’ and 25% of this can be withdrawn as tax-free after the age of 75.

Due to the complexity of this calculation, it is advisable to speak to an expert before making a lump sum withdrawal after you reach 75 years old.

What is protected tax-free cash?

Protected tax-free cash, otherwise known as scheme specific tax-free cash, is when a pension member had an entitlement of more than 25% tax-free cash on 6 April 2006 (‘A-day’). The level of tax-free cash increased in relation to the pension lifetime allowance but did not decrease when the allowance was subsequently reduced. It also increased in line with an increase in fund value. However, this can be lost if the scheme is transferred out, unless this transfer is made via a scheme wind-up or block transfer.

What is enhanced protection?

Enhanced protection is either a set percentage of protected tax-free cash, or a maximum of £375,000. An enhanced protection certificate, issued by HMRC will state if there is any protected tax-free cash, which is presented as a percentage of the fund value. For example, if it states 18% then the tax-free cash is limited to 18% of the fund value. There is no maximum amount and the only limiting factor will be the value of the fund. This could be more than £375,000. If there is no percentage confirmed on the certificate, then the tax-free cash available is £375,000.

Enhanced protection had to be applied for by June 2009. If you didn’t apply for it by then, there are very limited, exceptional circumstances where it is issued after this date.

How does the rule of recycling work in relation to tax-free cash?

Recycling prevents a pension scheme member from drawing out tax-free cash only to put it straight back into a pension to enjoy greater Income Tax relief on their investment. Recycling will be deemed to have occurred if:

    • any tax-free cash taken in the last 12 months is more than £7,500 and

    • pension contributions then increase by more than 30% and more than 30% of the tax-free cash available is taken and

    • the recycling has been pre-planned by the pension scheme member.

If recycling takes place, an unauthorised payment tax charge will be applied.

In what circumstances can I take the whole of my pension as a tax-free lump sum?

If you become terminally ill and you’re under the age of 75 and have enough pension lifetime allowance available, you can take the whole of your pension as a tax-free lump sum. Many pension providers require a medical certificate before they can make the payment and it usually needs to be signed by a doctor (sometimes two), confirming the details of your condition and prognosis.

Your provider will then pay out as much of your pension as you want. It is important to bear in mind that if there is any money left when you die and it has left the pension, it will form a part of your estate and potentially be liable to Inheritance Tax. If it stays within the pension, it will fall outside of your estate and can be passed on free of Inheritance Tax.

Talk to Evelyn Partners

If you are planning to take a lump sum from your pension, you could benefit from speaking to Evelyn Partners first. We can show you how much you can afford to withdraw and consider the best way to do so based on your individual circumstances. Book an initial consultation online or call us on 020 7189 2400.

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This article does not constitute personal advice. If you are in doubt as to the suitability of a particular course of action please contact one of our advisers. Please also see the Important information below.


This article was previously published on Tilney prior to the launch of Evelyn Partners.