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

Being able to take a tax-free lump sum out of your pension when you reach pension age certainly sounds appealing. It can help you kick-start retirement plans and fully enjoy the milestone, but is it always the right decision to make?

Currently, you’re able to take a 25% lump sum from your private pension at retirement age without incurring Income Tax liability. This option is usually available once you’ve passed the age of 55 but is set to increase to 57 in 2028. Once you take your ‘pension commencement lump sum’, your scheme is ‘crystallised’, and you should decide what you want to do with the rest of the fund.

Whilst taking a lump sum is a popular option and right for some people, you don’t have to take it.

If you’re thinking about taking advantage of the tax-free lump sum, there are two questions to ask yourself first:

  • What do I intend to do with the lump sum?
  • How will it affect my long-term finances?

Setting out plans for the withdrawn lump sum

The first thing to consider is why you want to take a lump sum out of your pension. You should have a clear plan about what you want to achieve with the money before you proceed.

In some cases, taking a lump sum out of your pension can make the first years of retirement more enjoyable and improve financial security. Perhaps you’d like to use it to pay off your mortgage before giving up work full-time or maybe you have plans to celebrate retirement with a once in a lifetime experience. There are plenty of reasons why a lump sum may be appealing.

However, there are plans where taking out a lump sum may not make sense financially.

Recent research asked retirees taking taxed lump sums from their pension in the last year about their plans, revealing an insight into why people make withdrawals from their pension. The top two priorities were to add the money to a savings account or simply put it in the bank. It’s prudent to have an emergency fund you can fall back on if needed but having too much held in cash can be a bad thing too. Interest rates are low and it’s likely pension lump sums withdrawn to sit in the bank will be losing value in real terms.

One in ten people also took pension cash with the plan to reinvest the money back in stocks and shares. If you’ve chosen to access your pension flexibly, it will usually remain invested until withdrawn. As a result, it’s important to look at the balance of your investments and why you’re withdrawing pension investments, where returns aren’t taxed, to other products that could face Capital Gains Tax.

Before making any pension lump sum withdrawal decide how you’ll use the money and weigh up if it’s the best course of action with your goals in mind.

Understanding the long-term impact

It’s also important to look at the bigger picture. After all, you saved into a pension for decades in order to create an income that will last you the rest of your life. Taking a lump sum out of your pension during the early years of retirement can have a long-lasting impact.

Before you take action, assessing what a lump sum withdrawal means over the long term is important. With modern retirement spanning several decades, it can be difficult to know if using a lump sum at the start of retirement will have an impact 20 or 30 years’ down the line. This is where financial planning can help.

By understanding the lifestyle you want to achieve throughout retirement, we’ll be able to help you see if that’s achievable under different scenarios, including after you’ve taken a lump sum. The good news is that we often find retirees are in a position to meet their short and long-term retirement goals. Careful financial planning and considering the long term gives you the peace of mind to fully enjoy your retirement years both now and in the future.

At the point of retirement, there are numerous decisions to be made, from when and how you actually want to retire to how to access your retirement savings. We’re here to make your transition into retirement as smooth as possible, please contact us to discuss your aspirations for the future and how your saving can help you achieve them.

Please note: A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.

The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.