There’s no right or wrong decision about whether to take a tax-free lump sum from a pension.
However, any pension cash spent before retirement will diminish the pot of money available to fund a comfortable retirement.
Savers who dip into their pot too much risk running out of money in their final years.
This guide explains all you need to know about taking a tax-free lump sum from a workplace, private or state pension.
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Pension Tax-Free Lump Sums Explained
The government offers pension tax relief as an incentive to save for retirement.
Although savers see the relief as a refund of tax paid, the arrangement is a way of delaying tax until any income is drawn from the pension. The exception is the 25 per cent tax-free lump sum, which is more of a reward for staying the saving course.
Defined benefit (DB) and defined contribution (DC) pensions both offer tax-free lump sums.
DB or final salary schemes have no fund value, so the lump sum is calculated according to length of service and commutation rules.
DC scheme lump sums are simply 25 per cent of the fund value.
When Can I Start Drawing My Pension?
If you are fit and healthy, you can’t draw your workplace or private pension until the age of 55 without a hefty tax penalty.
In April 2028, this age limit rises to 57 years old.
To take the money earlier is an ‘unauthorised withdrawal’, which is taxed at the rate of 55 per cent of any money withdrawn.
Some firms promote early pension access or liberation, but unless you are in poor health or have one of the few jobs that recognises early retirement, they are scams that come with high fees.
The age limits apply to expats with an international SIPP (Self-Invested Personal Pension) or QROPS (Qualifying Recognised Overseas Pension Scheme).
DC Pension Tax-Free Lump Sums
A DC pension is a retirement fund built up from personal and employer contributions and investment returns.
Under pension access rules, anyone can take a 25 per cent tax-free lump sum, providing:
- The scheme rules allow the withdrawal
- The retirement saver has reached their 55th birthday
Taking the lump sum triggers a list of prompts of what to do with the rest of the money:
- Keep the fund invested within the pension to take further lump sums
- Cash in the entire fund
- Buy an annuity with the fund
While the fund is invested, retirement savers can take more cash lump sums as income drawdown. The sums are a regular income or ad hoc withdrawals whenever they wish.
DB Pension Tax-Free Lump Sums
Your retirement income from a DB pension is calculated with a formula that takes into account how long you have worked for an employer and your final or career average salary.
Any tax-free lump sum is based on the scheme’s commutation rules. If you commute your pension, you take money upfront. Some monthly income is given up in return for taking the lump sum.
Calculating the tax-free lump sum
The amount you can withdraw tax-free varies between DB schemes, which may have different rules, so check with your scheme administrator to make sure you use the right figures in your workings.
The pension will have a commutation factor, which is something like 14 or 15. The higher the factor, the more money you receive. Many public service schemes calculate lump sums with a commutation factor of 12.
For a DB pension paying £20,000 a year with a commutation factor of 12, the calculation is:
20 x Commutation factor x Annual pension before commutation, divided by 20 + ( 3 x Commutation factor)
For example,
20 x 12 x 20,000 / 20 + 36 = 4,800,000 / 56 = £85,714 tax-free lump sum
But don’t forget pension income decreases with commutation, leaving what’s called the residual pension. The residual pension is calculated as:
Annual pension less the lump sum divided by the commutation factor
For example,
£20,000 – £85,714 / 12 = £20,000 – £7,143 = £12,857
The result is the annual pension payment after commutation of a £85,714 tax-free lump sum is £12,857 a year.
DB pension retirement savers commuting a tax-free lump sum can divide the tax-free lump sum by their pension reduction to give the number of years the reduction is worthwhile.
For example:
£85,714 / £7,143 = 11.99 years
What Is A Pension’s UFPLS?
An UFPLS is an uncrystallised funds pension lump sum. This is the term for operating your pension, like dipping into a savings account for odd sums of cash whenever you like.
Each time you take some cash, you get 25 per cent tax free and pay income tax at your normal rate on the rest.
UFPLS is only available if you have not taken any money from your pension fund. Once you trigger UFPLS, the maximum tax-relieved savings you can put into a pension going forward is £4,000 a year.
Is Taking A Pension Lump Sum Worth It?
Taking a tax-free lump sum from your pension comes with two main concerns:
- Tax implications
- Concerns you may run out of money during retirement
Planning your spending and spreading your withdrawals over several years to keep your taxable income low is always a good idea.
Taking lump sums is worthwhile if you want to take varying amounts of cash from each withdrawal at irregular times.
Don’t take lump sums if you worry you may run out of money or need a regular sum to live on that exceeds your state pension.
Taking A Pension Lump Sum FAQ
Can I take the state pension as a lump sum?
The state pension has no lump sum option. However, you can defer collecting your state pension for a year. In return, the government pays interest at the official base rate plus 2 per cent. That’s currently 3.25 per cent interest a year.
Does taking a lump sum affect benefits?
Yes. You must declare any pension payments you receive when applying for any means-tested benefits, like tax credits and housing benefits.
Do I declare pension lump sums to HMRC?
A tax-free lump sum does not need to go on a self-assessment return. You should tell the taxman about other withdrawals as they may affect the amount you earn that is taxed.
Can I take a pension lump sum and carry on working?
Yes. You may have a decade or more working if you take a lump sum when you are 55. The amount you withdraw may imp[act the income tax you pay, so check the figures before committing to take the money.
I have more than one pension – can I take cash from each?
Each separate pension should let you take a tax-free lump sum.
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