Should you collect your pension as a tax-free lump sum?

Investors who turn 55 (57 from 2028) can access their pension pot, but what’s the best way to do it?

Many choose to subscribe to their Pensionable Income Amount (PCLA) of up to 25%, which comes tax-free. But this is not always the best option.

Below, Carina Chambers, technical pensions expert at digital wealth manager Moneyfarm, highlights the pros and cons to consider.

Benefits of withdrawing cash

The 25% lump sum can help cover large expenses. Chambers said the priority for many retirees is helping family members pay for weddings or education, but other projects this lump sum can also cover include home renovations, paying off debt and mortgages, or going on vacation.

There is also a strategic advantage to utilizing the lump sum, as any amount over and above the tax-free lump sum will be taxed as income.

“By taking the tax-free portion up front, you reduce the size of your pension pool and therefore the amount that will be subject to income tax on future withdrawals,” Chambers said.

Patience is a virtue

Withdrawing that lump sum will reduce the size of your pension pot and thus the benefits of growth from your investments, potentially leading to less income in the later years of retirement.

“Waiting a few years before accessing your 25% tax-free allowance can result in a larger amount you can take tax-free in the future, plus a larger income in retirement that may be needed for unforeseen costs or care later in life.” Chambers said.

For a practical example: on a pension pot of £400,000, the tax-free allowance would be £100,000. But leaving the full £400,000 invested for a further five years could grow to £510,512 if the markets do well and add an average return of 5% per annum.

“This means your tax-free allowance will increase to £127,628, giving you a higher tax-free lump sum,” she said.

Another risk is inflation – if that lump sum is not used up and left as cash, inflation will erode the value; and if reinvested it will be taxable.

Chambers therefore suggested withdrawing only what you need when you need it, “otherwise the best place for the cash is probably to be invested in your pension”.

Within a pension package, capital gains, dividends and interest are completely shielded from tax. “Taking the tax-free sum is an irreversible process where you move from a tax-efficient vehicle to a non-tax-efficient environment, so it’s important to make an informed decision,” she warned.

Retirement investments have a high statistical probability of outperforming cash, but ultimately the decision will depend on the individual’s circumstances, needs and wants, she said.

“Remember, you don’t have to take the full 25% at once. It’s just the tax-free limit, not what to take,” she concluded.