Quick answer
The 25% tax-free rule
When you access a defined contribution pension, you can take up to 25% of the fund as a tax-free lump sum. This is one of the most valuable benefits of a pension, money that comes out completely free of income tax, regardless of your other income.
The 25% rule applies to each pension pot separately. If you have multiple pension pots, you can take 25% of each one tax-free, subject to the overall lump sum allowance.
The lump sum allowance
The lump sum allowance (introduced in April 2024 to replace the old lifetime allowance) limits the total tax-free cash you can take from all your pensions over your lifetime to £268,275. If your total pension pots are worth more than £1,073,100, the 25% rule still applies to each pot, but the total tax-free cash across all pots is capped at £268,275.
For most people, the lump sum allowance is not a constraint, you would need a very large pension pot to exceed it. However, if you have multiple pension pots or a large defined benefit pension, it is worth checking whether the allowance affects you.
Taking tax-free cash in stages
You do not have to take all your tax-free cash at once. There are two main ways to take it in stages:
Phased drawdown, you designate a portion of your pot to drawdown at a time, taking 25% of that portion as tax-free cash and moving the rest into drawdown. You can repeat this process over time, taking tax-free cash in stages while keeping the rest invested.
UFPLS (uncrystallised funds pension lump sum), each withdrawal you make is 25% tax-free and 75% taxable. This is simpler than phased drawdown but means you cannot separate the tax-free and taxable elements.
Steve's observation
The tax-free cash is one of the most valuable features of a pension, but how you take it matters enormously. Taking your entire tax-free cash in one go in a single tax year can be a mistake, particularly if you do not need all the money immediately.
By taking tax-free cash in stages over several years, you can manage your overall tax position much more effectively. Combined with careful management of the taxable withdrawals, it is possible to take a significant amount from your pension while paying very little tax. This is an area where planning ahead, ideally with advice, can make a very significant difference.
Tax on the remaining 75%
The remaining 75% of your pension pot is subject to income tax when you take it. It is added to your other income in the tax year and taxed at your marginal rate. If you take a large amount in a single year, it could push you into a higher tax bracket.
By spreading withdrawals over multiple tax years, you can keep your total income within a lower tax band and reduce the overall tax you pay. This is one of the key advantages of drawdown over taking your whole pot at once.
Taking your whole pot as cash
You can take your entire pension pot as a cash lump sum, but this is rarely advisable. Only 25% will be tax-free, the remaining 75% will be subject to income tax in the year you take it. For a large pot, this could result in a very significant tax bill and push you into the additional-rate tax band.
There may be circumstances where taking a large lump sum makes sense, for example, to pay off a mortgage or fund a specific purchase. But the tax implications should always be carefully considered first.
Impact on future contributions
Taking a tax-free lump sum alone (without taking any taxable income flexibly) does not trigger the money purchase annual allowance (MPAA). However, if you also take taxable income from your pension flexibly, for example, through drawdown, the MPAA is triggered, reducing your annual allowance for future pension contributions to £10,000.
If you are still working and contributing to a pension, triggering the MPAA could significantly limit your ability to continue building your pot. This is an important consideration if you plan to access your pension while still employed.
Pause for thought
- Do you know how much tax-free cash you are entitled to from your pension pots?
- Have you considered whether to take your tax-free cash all at once or in stages?
- Are you aware of the tax implications of taking large withdrawals from your pension in a single tax year?
- If you are still working, have you considered the impact of the money purchase annual allowance on your future contributions?
Coaching point
Key terms
Frequently asked questions
What to do next
Think about how you want to take your tax-free cash, all at once or in stages, and consider the tax implications of different approaches. Guide 18 explains pension drawdown in detail.