The 25% tax-free pension lump sum: take it or leave it?

A key perk of saving into a pension is the option to take up to a quarter of your savings as a tax-free lump sum. But is this always the best approach when it comes to future planning? Here, we explore the various options available.

Many pensions allow you to take a 25% tax-free lump sum, usually from the age of 55. Unsurprisingly, this is one of the most popular features of the pensions system, as the money can be put towards a number of meaningful causes – a special holiday as a retirement treat, helping a son or daughter to buy their first home, or clearing any existing debt/mortgages. Yet this option is much more complicated than it used to be.

An increase in flexibility

In the last few years, pensions have become much more flexible – 2015’s Pension Freedom completely revolutionised the industry. Before this, many people simply took all their tax-free cash up front and used the remaining amount to purchase an annuity, which would provide them with an income for life.

But today, a defined contribution pension can be taken in a variety of ways. You can now keep your money invested in a fund for longer and take 25% tax free every time you make a withdrawal from the pot. Furthermore, your pension pot can now be more easily left as part of a tax-free inheritance. As long as the money remains in the pension, it can be passed to heirs free of Inheritance Tax (IHT) – and potentially free of Income Tax, depending on certain conditions.

Unless you have specific plans for the 25% of your pension pot, there are clear benefits to keeping your pension intact. The favourable tax treatment means that, in many circumstances, it can make sense to draw income from alternative sources in retirement, so a greater value of the pension can potentially pass to loved ones in a tax-efficient manner.

Leaving the pension untouched also means that the investments can potentially benefit from more years of tax-efficient growth, which could make a big difference to the amount of income available to you or your family in the future.

The statistics

The ability to take tax-free cash is no doubt an attractive option, and many individuals still choose to receive it at the outset. A recent survey by Aegon found that some 54% of savers plan to take their tax-free lump sum at retirement, with 15% intending to put this money into a bank account. The potential problem with this approach is that these accounts often offer derisory rates of interest, and are potentially subject to IHT.

“Once you take your tax-free cash from your pension, that money becomes part of your estate,” says Ian Price, Divisional Director at St. James’s Place. “Putting it in a bank account will also generally limit its ability to grow tax-efficiently in future. So, unless you have a definite plan for the cash, it may be better to defer taking pension benefits, including your tax-free entitlement.”

“Retirees might want to consider utilising their taxable savings first, then their ISAs, and then their pension last. That may sound odd, but by doing so they can ensure that that their pension, which is generally the most tax-efficient way of saving, is shielded from HMRC for as long as possible.”

The best approach for you

Pension Freedom allows you the flexibility to dip into your pension savings if needed; however, there are tax-efficient ways of doing this. A good way to minimise tax is to phase withdrawals by combining small amounts of tax-free cash and taxable withdrawals to meet the need for income or capital.

So rather than ‘crystallising’ the whole pension fund, a portion of it can be designated to provide benefits, with 25% of that amount being tax-free. This means that more of the fund can remain in the tax-efficient pension wrapper and hopefully grow in value to create more tax-free cash for the future.

Of course, many people will continue to take all their tax-free cash up front and then the rest of their pension gradually over time. The best approach really depends on your own individual circumstances and income needs – if you are unsure about the most suitable way to take your retirement benefits, we recommend seeking financial advice. Here at Wellesley, we can guide you through the available options and help you create a plan to ensure a comfortable future – whilst still being able to enjoy those well-earned treats after retiring.

For more information

If you have a question about receiving financial advice or would like more information about our services, please contact Wellesley Wealth Advisory on 01444 848508 or via email at

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