Five pension tax-free cash myths and misconceptions

Andrew King, pensions and retirement specialist at wealth management firm Evelyn Partners, says:

‘The 25 per cent tax-free entitlement is probably the most treasured feature of defined contribution pensions. Combined with tax relief at contribution stage it can make pension saving incredibly tax efficient and powerful. Taking it is also often the first thing that savers think about doing with their pension.

‘Rumours and speculation emerging before recent Budgets that tax-free cash could be further restricted* have provoked consternation and some panicked decision-making. But considering this is a well-known and jealously guarded feature of pensions, it is also widely misunderstood, with a variety of misconceptions around how it can be taken and what the implications are for the saver and their pension.

‘That is not surprising, because we each only arrive at this point once; it is not an issue many will have dealt with until they are taking the step. Plus pension rules can be complex and full of jargon. Here we hope to dispel a few common misunderstandings.’

The official name for this pensions feature is the Pensions Commencement Lump Sum (PCLS) but we shall use ‘tax-free cash’ or ‘TFC’ to refer to the 25 per cent tax-free entitlement available from most pension savings. In all instances, we recommend that you take financial advice to fully understand your options and the best way to fund your retirement.

1. You only have one shot at taking your tax-free cash

Andrew King says: ‘Many savers think that when they come to access their pension, it’s like going into a one-way street – you take your tax-free cash, and that’s it, your pension has been “crystallised” and there’s no going back. 

‘That’s totally wrong. You might end up with multiple pension accounts, drawdown and accumulation, but it’s far from the end of the road. Certain ways of accessing pensions can restrict future contributions (see 2 below) but even they do not prevent further pension saving, or even future tax-free cash.

‘You can take your tax-free cash as a lump sum at any point from the normal minimum pension age (55 currently, about to rise to 57 in 2028), and that does not stop you building your pension savings back up. Nor does it stop you taking more tax-free cash at a later date, as long as you are within the Lump Sum Allowance, which is currently £268,275 for most people.

‘So, for instance, if at age 60 you have built up a £600,000 pot and want to take out your 25 per cent TFC to pay down the mortgage, you can withdraw £150,000, and either leave the rest invested or put it into drawdown. If you are still working or have income from other means you can then build your pension back up over subsequent years, and still take up to £118,275 TFC at a later date - as long as you have sufficient pension funds to support the TFC. In this example, you would need to have a fund of £473,100.

‘Taking tax free cash from a final salary (defined benefit) pension scheme is treated differently. The pension scheme will give you limited options when taking benefits. This will firstly be an annual pension with zero TFC. You will then have the option to exchange some of your annual pension for a tax-free lump sum.

‘If you take this option, you will then receive a lower level of annual pension. But do remember that final salary pension scheme income is inflation-proofed during retirement and therefore that taking TFC will reduce the long-term benefit offered by such a pension scheme.’
 

2. Taking your TFC will limit how much you can pay into your pension in future years

Andrew says: ‘Accessing pension tax-free cash can be done in many different ways. As a rule of thumb, if you take taxable amounts over and above you TFC entitlement, this will trigger something called the “money purchase annual allowance”. Which means that the amount you are allowed to pay into your pension each year and still benefit from tax relief falls from the standard £60,000 for most savers (or their relevant earnings, if lower), to the MPAA of £10,000.

‘So, if you just take your TFC, you do not trigger the MPAA - as long as you do not also access your pension flexibly and take taxable amounts at the same time. If you simply take the TFC and leave the rest of the pot invested or in drawdown, then you don’t need to worry about the MPAA. This is important to note as many people who take their TFC want to build their pension pot back up afterwards (as noted in 1 above), and the MPAA could restrict that.’ 
 

3. You have to take your TFC as a single lump sum 

Andrew says: ‘This is probably the biggest misconception, encouraged by the fact that the pension tax-free cash entitlement is often referred to – even in the pensions and financial advice industry – as the “tax-free lump sum” (TFLS) or “pension commencement lump sum" (PCLS). This is arguably not helpful as it disguises the fact that you can choose to take your TFC in tranches, either regular or ad hoc.

‘And for many savers, this strategy can make a pension pot go further in the long term, because, rather than taking out a large sum from the pot at an early stage, it leaves more funds in the pension to grow tax-efficiently and benefit from compounded returns over the subsequent years. It could also make it easier to manage future income tax liabilities.

‘Care must be taken, however, with how this is done. Flexible drawdown is generally the preferable option, which means that you crystallise part of your pot with each TFC withdrawal, with the other 75 per cent going into drawdown. The alternative is “uncrystallised funds pension lump sum” withdrawals where you take lump sums directly from your pension without moving anything into drawdown. Of each withdrawal, 75 per cent will be immediately taxable, and so this does trigger the MPAA.’

4. ‘Tax-free cash is bound to come under attack – I may as well take it as soon as possible!’

Andrew says: ‘OK this is not necessarily a myth, it is quite a rational reaction to the policy uncertainty of recent years. What must be remembered, however, is that it does not come without its costs.

‘It is not surprising that thousands of pension savers rushed to take their tax-free cash – or seriously considered it - before the October 2024 Budget, and to a lesser extent before the November 2025 one, because speculation was rife that the Chancellor was set to further restrict or remove this pension entitlement, beyond the existing lifetime cap. Speculation that the Treasury did nothing, unfortunately, to quash.

‘Some of those who took this step later regretted it, as no TFC crack-down has emerged and they were then left wondering what to do with a big lump sum that they had taken out of a tax-free environment, where it had been growing with compounded investment returns. It doesn’t help that equity markets have risen quite significant over recent years, which might deepen the sense of regret. Others who had a purpose or a plan for their TFC were more unphased when the TFC removal fears proved unfounded.

‘That is the main point about taking TFC as a lump sum: only do it if you have a well-thought out plan for it, and you are confident it will not leave you short later in retirement. Of course, extraneous factors might well influence the timing of TFC withdrawal, and we are seeing this at the moment due to the inclusion of unused pension assets in inheritance tax calculations from April next year. The forthcoming rise of the pension access age to 57 might also be encouraging some savers of certain ages to bring forward a TFC withdrawal.

‘Any speculation around TFC before the next Budget with doubtless – and understandably – further fuel such behaviour, but we would advise against acting on policy fears alone.

‘One last warning is for those who might think, “Even if I take my TFC and they don’t crack down, I’ll just pay it back in.” Paying significant amounts back into a pension immediately after having taken TFC might be picked up on by HM Revenue & Customs as falling foul of “pension recycling” rules. So, it would be unwise to simply try and pay big lump sums back into your pension in the same tax year you have taken TFC, or the following two years.’   
 

5. ‘I can cash in my small pots tax-free'

Andrew says: ‘Wrong. There are “small pot rules”, but they don’t really confer any tax advantage.

‘Their main benefit is that, as long as you are above pension access age, they allow you to cash in pots of less than £10,000 without triggering the MPAA – and without having to partially crystallise and have a drawdown account. But this can usually only be done with three small pots and only a quarter of each pot will be tax-free, with the other 75 per cent being taxable.

‘That could add quite substantially to the tax bill for someone who is cashing in several small pots in one tax year, especially if they were still working or had taxable income from other sources, as it could take them into a higher tax bracket.

‘The employees of today will be more likely to accumulate multiple small pots through their careers as they shift from job to job. One fallacy these savers must avoid is to assume that these pots are “pointless” and – as soon as they can - use small pot rules to get rid of them. Because, once consolidated – for example, into a Self-Invested Personal Pension, or into your latest active workplace pension - and left to grow with tax-free compounded returns, these sums could eventually make a substantial contribution to retirement income.’

* The Lump Sum Allowance (LSA) of £268,275 effectively puts a lifetime cap on the amount of tax-free cash that can be taken from all pension savings.