As Franklin D. Roosevelt famously said, “Taxes are paid through the hard work of every labourer.” So, when the opportunity to reclaim a portion of that effort arises - by taking 25% of your pension as a tax-free lump sum - it’s definitely an appealing option.

However, choosing to take a large pension lump sum isn't always the best option for everyone. While it can be tempting to access a significant amount of money upfront, there are important considerations to keep in mind. The decision can impact your long-term financial security and tax situation. Here’s a closer look at the pros and cons of taking a lump sum versus other options available to you.

How does the 25% tax-free lump sum work?

When you reach the  pension access age, most individuals can withdraw 25% of their pension pot tax-free (it’s important to note that some many have a higher rate of tax free cash), while the remaining 75% will be subject to income tax. Most people don’t need to withdraw their entire tax-free amount in one go. Typically, you can take out as much or as little as you wish, provided that your pension provider offers the right product to support this flexibility.

For defined contribution pension plans, you can withdraw 25% tax-free from each plan that you hold. However, this is subject to the Lump Sum Allowance. The most you can take is £268,275.

You have the option to withdraw only taxable money before accessing your full tax-free lump sum, especially if you opt for a flexible income (drawdown) and your pension provider allows it. However, you must ensure that your 'drawdown pot' contains enough funds to cover any taxable income you wish to take. Additionally, you can withdraw tax-free and taxable money simultaneously, provided that your pension provider can accommodate this.

For more information on how the 25% tax-free lump sum works, MoneyHelper has some free and impartial advice on their website.

Will this impact any other areas of my finances?

Yes, taking the 25% tax-free lump sum from your pension can impact other areas of your finances in several ways.

Firstly, there are tax implications. While the lump sum itself is tax-free, withdrawing it could impact your income tax for the year[NM5] . [LH6] If you take a axable withdrawal afterward, it could push you into a higher tax bracket, resulting in higher taxes on that income.

It can impact future income. Taking a lump sum can reduce the amount of money remaining in your pension pot, potentially affecting your future retirement income. This could lead to a lower overall income in retirement, especially if you draw down your pension quickly.

However, it can also provide investment opportunities. The lump sum can provide you with capital to invest elsewhere, potentially leading to growth in other assets. However, this also comes with risk, as investments can fluctuate in value. You should also consider that you are moving money from an area where all gains are CGT free, to an area where you may pay CGT on any gains made.

Accessing the lump sum might influence your savings strategy. You may decide to allocate funds to short-term savings, long-term investments, or even pay off debts, all of which can change your financial landscape.

Furthermore, receiving a large lump sum could affect your eligibility for certain benefits or means-tested support. It’s important to understand how changes in your income and assets may influence your eligibility for government assistance.

The lump sum could be used to bolster your emergency fund, providing a financial cushion for unexpected expenses. This can enhance your overall financial security.

In summary, while the 25% tax-free lump sum can offer immediate financial benefits, it’s essential to consider how it may influence your broader financial situation, including taxes, future income, and your overall financial strategy.

At Reeves Independent, we have developed an essential guide to tax planning tips for savers. This resource is designed to help you cover all aspects of your tax planning, ensuring you maximise your savings and minimise your tax liabilities.

Autumn Budget: Were there any changes to the 25% tax-free lump sum?

The recent Autumn Budget has not made any changes to the 25% tax-free pension lump sum. There were concerns and speculation regarding potential adjustments to this benefit, especially as the government considers various measures to raise revenue. However, the Budget did not include any alterations to the tax-free lump sum option, which allows individuals over 55 to withdraw a quarter of their pension pot without incurring tax​.

It's important to keep in mind that while there were no changes announced, pension experts have pointed out this doesn't necessarily mean the 25% tax free cash wont be targeted in future budgets. The tax-free lump sum is a significant feature for many retirees, and modifications could affect retirement planning for countless individuals.

Following the Budget, if you're curious about how a Labour government under Prime Minister Keir Starmer may influence the markets, be sure to read our informative article. It explores the potential impacts of his newly formed government on various sectors and economic conditions. Check it out for valuable insights!

Pros and cons

Taking a tax-free lump sum from your pension comes with both advantages and disadvantages.

The pros:

Firstly, If you expect to be subject to higher rate income tax on your retirement income, it can be more tax-efficient to maximise your tax-free lump sum withdrawal from your pension. By doing so, you can effectively reduce your taxable income during retirement, allowing you to retain more of your savings. This strategy is particularly beneficial if you anticipate that your pension income will push you into a higher tax bracket.

Secondly, in 2027 pensions will become part of your estate for inheritance tax, so you may want to speak to a financial adviser about what options you have to pass on your wealth.

Gifts to your children that are made at least seven years before your death are not subject to inheritance tax (IHT). If a gift is made within the seven years prior to your passing, the amount that is exempt from tax will gradually decrease due to “taper relief.” Specifically, if you pass away within three years of making a gift, the entire amount will be counted towards your IHT calculations.

Keep in mind that your children may struggle to cover any tax charges that arise, especially if they have already spent the gifted funds.

Thirdly, having extra income available when you need it can be incredibly beneficial. While postponing withdrawals from your pension may allow your funds to grow, you may prefer having immediate access to income to support your hobbies and activities while you're still young and active. By opting for a larger tax-free lump sum, you can secure the lifestyle you desire, while also putting your pension funds to work in a well-managed investment portfolio.

As time goes on, it's likely that your level of activity will decrease, and any future lump sums you take may end up going unspent. It's often wiser to access the cash when you need it rather than waiting, ensuring that you can enjoy the benefits of your hard-earned savings now.

The cons:

Firstly, selling assets to take a large tax-free lump sum during a market downturn can put your future income at risk. While this may not seem immediately apparent, the problem lies in crystallising paper losses by making withdrawals when market prices are low.

When you take a lump sum while the market is down, you effectively lock in your losses, making it harder to regain your original investment position. For example, if you withdraw a 25% lump sum while market prices have fallen by 10%, the market will need to rebound by approximately 14.8% just to return to your initial value. Given that a swift recovery isn't guaranteed, this strategy could lead to a reduced pension pot compared to waiting for the market to improve before making your withdrawal.

Ultimately, a smaller pension can adversely affect your future income, making it crucial to consider the timing of your withdrawals.

Secondly, funds remaining in your pension can be passed on to your spouse or civil partner tax free. If you pass away before the age of 75 and your pension pot is below £1.05 million, your beneficiaries can withdraw the entire amount without facing any tax liability. However, if you die after age 75, they will only be required to pay income tax on withdrawals at their marginal rate.

In contrast, if you gift the same amount shortly before your death, it would be subject to inheritance tax at a rate of 40%. For example, a basic rate taxpayer receiving a £100,000 gift that incurs inheritance tax would face a liability of £40,000. If the same amount were withdrawn from the pension gradually, keeping the beneficiary's total income below the higher-rate tax threshold, the tax charge could be reduced to just £20,000.

This illustrates how strategic planning around pensions can provide significant tax advantages for your heirs.

Lastly, keeping your money invested in your pension allows for greater flexibility in the future. By doing so, your funds can continue to grow in a tax-efficient manner throughout your retirement, enhancing your financial security.

Additionally, delaying the purchase of an annuity may result in lower costs, as it allows you to benefit from potential market growth over time. You may also choose to withdraw a tax-free lump sum at a later date when market conditions are more favourable, maximising the value of your withdrawal.

Taking the 25% tax-free lump sum from your pension offers immediate access to cash and potential inheritance tax benefits, but it can also reduce your long-term retirement income and expose you to market risks. It’s crucial to weigh these pros and cons carefully.

Reeves can assist you in navigating these financial decisions, ensuring you understand the implications and helping you create a comprehensive retirement strategy. For personalised advice, book a free pension and retirement review today to start your journey towards a brighter, more sustainable future.