Why taking your pension tax-free lump sum could leave you thousands of pounds worse off

Receiving a tax-free lump sum is one of the biggest advantages of paying into a pension.

Savers often use their 25 percent tax-free cash to pay off remaining mortgages, spend on new cars, home renovations and trips abroad, and even ease daily living costs.

But not everyone should rush to save money once they reach their mid-50s. Withdrawing money too early can leave you thousands of dollars worse off in the long run.

Currently, people over 55 (rising to 57 from 2028) will be able to receive 25 per cent of their pension tax-free, up to a limit of £268,275.

According to official figures, savers collectively withdrew a massive £3.9bn from their pensions in the 12 months to October; This is an 81 percent increase compared to the same period in 2022/23.

Withdrawals have soared ahead of the Autumn Budget 2025, amid rumors that the Labor government is ready to cut bonuses.

Last year, nearly 116,000 people took a lump sum pension withdrawal at age 55, totaling £2.3bn, according to wealth manager Lubbock Fine Wealth Management.

This is up from the 84,200 55-year-old savers who withdrew £1.7bn in the 2020/21 tax year five years ago.

However, taking money from your pension should not be taken lightly; This could have important consequences for the future.

Andrew Tricker, financial planner at Lubbock Fine, says: ‘It’s worrying that more people are filling up their retirement funds so long before the normal retirement age.

Some take too much, too soon. ‘If they don’t plan carefully, they may face financial difficulties in retirement.’

Years of lost retirement income

Most savers receive a tax-free lump sum without a clear plan for what to do with the money.

Keeping cash in the bank often seems like a safe and easy option; but this is not the case. Money taken out of a pension loses its ability to continue growing tax-free and tends to be stashed away in a savings account where the growth will be taxed.

Savers will also have difficulty growing their money and keeping up with the economy. inflation.

For example, according to calculations by wealth manager Broadstone, a person with a £400,000 pension pot who withdraws 25 per cent of it as a tax-free lump sum (£100,000) and leaves it in a savings account earning 3 per cent interest a year will have around £134,000 when they retire in ten years.

If the remaining pension had continued to rise by 5 per cent a year, after ten years this figure would have reached £448,688, giving a total value of £582,688.

However, if they had continued to grow until age 65 without taking out the full £400,000 pension pot in tax-free cash, this could have reached £651,558 – an extra £68,870.

They will now also be able to withdraw a much larger sum of £162,889 free of 25 per cent tax.

Scottish Widows’ retirement expert Robert Cochran says loss of investment income isn’t the only downside to converting money into cash.

For example, if the lump sum remains in the bank, savers run a high risk of receiving a tax bill. Because they can easily violate the personal savings allowance, which is the amount of interest they can earn before paying taxes. Basic rate taxpayers can earn their first £1,000 tax-free in non-Isa ordinary savings accounts.

Anything above that is taxed accordingly income tax by 20 percent.

Those paying the higher rate receive a £500 allowance, while those paying the additional 45 per cent receive no allowance at all.

Money in the bank may also struggle to keep up with inflation, meaning it loses real value. That’s because easy-to-access savings accounts currently typically pay out less than inflation.

Broadstone’s Kelly Parsons says: ‘The difference really adds up over time and can make a tangible difference to your standard of living in retirement.’

We’re playing the long game

Around 42 per cent of savers plan to receive the entire tax-free lump sum in one go, according to research from pensions provider Standard Life. Many people see this as a good way to start their retirement journey, according to a survey.

But there is another option that may leave you better off in the long run.

Savers can benefit from their pensions flexibly, buying as much as they need, when they need it. When they do so, 25 percent of each withdrawal will be tax-free, with the remainder liable at the ordinary income tax rate.

For example, on a £10,000 withdrawal, £2,500 will be tax-free and the rest will be at your ordinary income tax rate. This approach can be especially effective for those who are currently working because it is easier to make withdrawals tax efficient by keeping them below income tax thresholds.

Cochran says: ‘Spreading your tax-free cash over years can help you manage your income tax.’

Flexible drawer can also help the pot last longer. Investing more money for growth may mean you withdraw more money in the long run. This is especially important for those who want to make sure their money will last for the rest of their lives and are concerned about possible maintenance fees later in life.

Take, for example, a 55-year-old with a pot of £400,000 who withdraws the entire tax-free lump sum and leaves the remaining £300,000 invested.

Let’s assume this increases by 5 per cent a year and the saver withdraws £20,000 a year from the pot. After 20 years they had withdrawn a total of £500,000 and had £180,000 left to invest; total pension benefit is £680,000.

Alternatively, they could leave the full £400,000 deposited and use the ‘flexible access’ draw to receive £20,000 a year, with £5,000 of each withdrawal tax-free. After 20 years, they will have withdrawn £400,000 and deposited £310,000; total pension benefit is £710,000.

The best option for you will depend on whether you need the money in the short term and what your long-term plans are. Parsons says: ‘This strategy can really help growth and reduce the amount of money held unnecessarily in retirement. ‘It may seem like a small decision at first, but it can have a surprisingly big impact on your retirement over 20 or 30 years.’

Beware of losing valuable privileges

Suddenly experiencing an unexpected event can skew your finances and mean you miss out on other important payments.

For example, it may affect your eligibility for means-tested benefits such as Pension Credit. People aged 66 and over with a weekly income of less than £238 may be eligible for this payment, and being eligible could open the door to other benefits such as a free TV license and winter fuel payment.

However, having a large amount of savings may affect your eligibility as it is included in your current income. This generally affects those with more than £10,000 in savings. HMRC says every £500 of savings above this amount counts as £1 per week of additional income.

Another big tax trap to be aware of is something called the ‘Money Purchase Annual Allowance’ (MPAA); but this usually comes into play if savers withdraw pensions beyond the tax-free lump sum.

If you take one penny more than your tax-free lump sum, the MPAA reduces the maximum amount you can contribute towards reducing your pension from £60,000 to £10,000 a year.

This can be a big problem for those still working and paying their pensions. At least 54 per cent of those accessing a pension for the first time in 2024/25 did so in a way that would trigger the MPAA, according to figures from the Financial Conduct Authority (the City regulator).

Parsons says: ‘These rules really highlight the importance of understanding the wider impact that pension withdrawals can have before making any decisions.’

When it makes sense to take a lump sum

There are many good reasons to withdraw your tax-free lump sum; This could be paying off the mortgage, helping the kids through college or getting on the property ladder, or simply covering day-to-day costs as you transition from full-time work to part-time work before retirement.

But money in a pension enjoys generous protections, including the ability to continue growing tax-free, so it’s important to have a clear plan.

‘A tax-free lump sum is a valuable option but should not be a default decision,’ says Parsons. ‘It’s important to understand how and when to use it and the trade-offs.’

Those who leave cash in the bank, even for a short time, should find the best savings rates and evaluate their cash. jesus allowance to avoid a tax bill on savings interest.

Cochran says: ‘This is a complex issue and getting professional advice can save you a lot of tax in the long run. After all, don’t take your tax-free cash just because you can; Only take it if you need it.’