Should You Take the 25% Tax-Free Lump Sum from Your Pension?

Reasons Against Taking the 25% Tax-Free Lump Sum

Loss of long-term tax-free growth

Pensions grow free of income tax and capital gains tax, and they benefit from tax relief on contributions. Taking money out reduces the amount left to grow in this highly tax-efficient wrapper. Over decades, the compounding effect of leaving money inside the pension can be substantial.

Risk of overspending

Receiving a large cash lump sum can tempt people to overspend early in retirement. Once it’s gone, it’s gone, and drawing on the pension later may result in taxable income. Keeping money inside the pension provides a natural brake on impulsive spending.

Impact on lifetime cash flow

Cashflow planning often shows that people underestimate how long they will live and how much they will need in later life (especially for care costs). Taking out too much too early could compromise your ability to sustain income over the full retirement horizon.

Reduced death benefits flexibility

As noted earlier, pensions are highly advantageous for inheritance tax. If you leave the money inside, it can be passed on free of inheritance tax, and depending on your age at death, your beneficiaries may pay no income tax either. Moving it outside could make it more taxable for your heirs.

Interaction with other allowances and benefits

Taking cash out could affect entitlement to certain benefits or allowances. For example, if you reinvest the lump sum into other vehicles that generate taxable income, you might lose your Personal Savings Allowance or see more of your income taxed at higher rates.

Potential loss of investment opportunity

If you move the tax-free cash into low-yielding bank accounts for “safety,” the real value may erode due to inflation. By contrast, keeping it inside the pension, invested for the long term, may deliver better growth.

Balancing the Decision

The decision is rarely all-or-nothing. You don’t have to take the full 25% in one go. Many pension schemes allow you to phase the lump sum. For example, you could take tax-free cash alongside regular drawdown, spreading the tax advantages over several years.

Here are some guiding questions:

1. Do you need the money right now?
   If not, leaving it invested may be more efficient.
2. What debts do you have?
   Clearing expensive borrowing with tax-free cash often makes strong financial sense.
3. What’s your health and life expectancy?
   If you expect a shorter retirement, front-loading spending via the lump sum may enhance your quality of life.
4. How important is legacy?
   If you want to pass on wealth, keeping money in the pension is usually best.
5. What’s your wider portfolio?
   If most of your wealth is in pensions, taking some out diversifies your tax risk. If you already have ISAs and other assets, you may not need to.

A Worked Example

Imagine Sarah has a pension pot of £400,000 at age 60. She is considering taking £100,000 tax-free.

• If she takes it now, she pays off her mortgage (£70,000) and keeps £30,000 in an ISA for flexibility. Her monthly outgoings fall, giving her more disposable income, but her remaining pension is £300,000.
• If she leaves it in, the whole £400,000 continues to grow inside the pension. Assuming 5% annual growth, after 10 years it could be £651,000. By contrast, if she had taken £100,000 out and invested it in an ISA at the same growth rate, the ISA might grow to £163,000 and her pension to £488,000 — a combined £651,000. Mathematically, it looks similar, but in practice, the tax and inheritance treatment will differ.

This shows that the decision isn’t just about growth, but about debt, flexibility, inheritance, and personal goals.

Conclusion

The ability to take 25% of your pension pot tax-free is one of the most valuable features of the UK retirement system. However, whether to use it immediately, delay it, or phase it in requires careful consideration.

• Good reasons to take it include clearing debts, diversifying assets, funding lifestyle goals, and enjoying peace of mind.
• Good reasons not to take it include preserving tax-efficient growth, protecting inheritance tax advantages, and safeguarding against longevity and overspending risks.

The “best” decision depends on your own financial plan, health, and family circumstances. A tailored cash flow model, projecting income, spending, and assets under different scenarios, is the most reliable way to make a decision.

For many people, a phased approach, taking tax-free cash gradually as and when needed, strikes the best balance between flexibility today and security tomorrow.

Next Step: Get Personalised Pension Advice

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