Taking your tax-free cash on your pension

Whether you’ve got a defined benefit or defined contribution pension, you’ll normally be able to take 25% of your retirement pot as a tax-free lump sum. 

You might hear this referred to as your ‘tax-free cash’ or your ‘pension commencement lump sum’ as it’s officially known. The remaining 75% of your pension will be taxed as income, once you start making withdrawals. 

Whatever your circumstances, your tax-free lump sum can give your retirement finances a helpful boost. You might use it to pay off your mortgage, invest in a new kitchen, or buy a new car. 

What you do with your tax-free cash is totally up to you, including whether you take it at all. 

The tax-free cash rules 

With most pensions, you can take 25% of your pot tax-free. However, the terms will depend on the type of pension you have. 

For defined contribution pensions, you’ll be able to withdraw the money from the age of 55 (rising to 57 in 2028), but with defined benefit pensions, the exact rules will depend on your scheme. 

Calculating how much you can take is straightforward for defined contribution schemes – it’s just 25% of your pot’s value. 

With defined benefit schemes, it’s a bit more complicated. Some schemes (typically public sector pensions) will pay a standalone lump sum in addition to your retirement income.  

However, others will ask you to give up or ‘commute’ some of your pension income for cash, for example, giving up £1 of income for £15 tax-free cash. 

The maximum tax-free cash that you can take out of pensions is capped at £268,275 for most people. This applies across your total retirement savings and isn’t a limit for each pot you’ve got. This is called the lump sum allowance. 

How to take a tax-free lump sum 

With a defined benefit pension, when and how you get your tax-free cash will depend on the exact terms of the scheme, but it will typically be when you reach the specified retirement age and start receiving an income. 

However, with a defined contribution, scheme you can take your 25% tax-free lump sum whenever you ‘crystallise’ your pension, for example, by purchasing an annuity or moving funds into income drawdown (but you don’t actually need to start taking an income to access your tax-free cash). 

If you take a lump sum out of your pension without crystallising any benefits, it’s referred to as an uncrystallised funds pension lump sum (UFPLS). In these cases, only the first 25% will be paid tax-free and you’ll need to pay income tax on the remainder. 

This means that if you want to take your tax-free entitlement as a lump sum, you will need to have made some decisions about how you plan to access your pension and use it to generate your retirement income. 

It’s also important to note that if you make an UFPLS withdrawal, you will trigger the money purchase annual allowance, which reduces the amount you can pay into your pension each year to just £10,000. 

If you just take tax-free cash and don’t start taking an income from your pot, you’ll keep the full annual allowance (100% of earnings up to £60,000). 

The earliest you can take your tax-free cash is 55 (rising to 57 in 2028)  unless you have serious health problems. Be wary of anyone that claims you can take it earlier, as it’s likely to be a pension scam. 

Do I have to take it all in one go? 

Although lots of retirees relish getting their hands on their tax-free cash and spend years mulling over what they’ll do with their ‘windfall’ –  if you’ve got a defined contribution pension, you don’t need to take it in one go. 

Instead, you can take your tax-free cash in stages. However, it’s important to remember that if you want the payment to be made entirely tax-free, you can only do it when you’re crystallising benefits. 

Let’s take the example of somebody with a £300,000 pot. They are entitled to £75,000 in tax-free cash (25%). However, if they preferred, they could crystallise £100,000, take £25,000 tax-free cash and move £75,000 into drawdown. The remaining £200,000 could be left in their pension until it’s needed. 

This could be a useful way of adding a bit more flexibility to your retirement plan. 

For example, many people now retire gradually – taking some tax-free cash could be a practical way of supplementing your earnings if you decide to reduce your hours in the run up to retirement. 

Alternatively, if you have fully retired, you could use tax-free cash to top up your taxable income, reducing the overall amount of income tax that you pay. 

The benefits of leaving your tax-free cash invested – for now 

It’s also important to note that there’s no requirement for you to take your tax-free cash when you turn 55 or retire, especially if you don’t have an immediate need or plan for the money. 

In fact, this could be a sensible option for some retirees. 

By leaving your money invested for longer, the more potential it has to grow – increasing not just the amount of tax-free cash you’ll be able to take further down the line, but also the income your pension will be able to generate. 

If you take too much out of your pension – and spend it – too soon, you may find that your pot doesn’t stretch as far as you hoped. 

However, for some savers, it won’t make sense to leave your tax-free cash invested indefinitely. If you die before the age of 75, all of your pension can be passed on to your loved ones tax free. 

But, if you die after age 75 any withdrawals will be taxed and you’ll have missed the opportunity to take a quarter of your pot tax-free. 

Speak to an expert pension adviser

Your tax-free cash can be a tantalising prospect, with lots of us viewing it is a timely reward for decades of saving. 

However, it’s important to think carefully about how you use this perk to your advantage. If you’re not sure what to do – or have any other questions about how to plan your retirement income – it’s worth talking to a regulated financial adviser. 

This is particularly important if you are thinking about giving your tax-free cash away to beat the new IHT and pension rules, which are being introduced in April 2027. 

A financial adviser can help you work out what to do and help you plan your retirement finances in a way that works for you.  

Unbiased can quickly match you with a qualified financial adviser.