Budget-scrutiny drives pension decisions as tax-free lump sum debated

Speculation that the Budget could curb or cap the 25 per cent tax-free lump sum from pensions is prompting savers to act quickly, according to financial advisers. Last year’s Budget did not tighten the rules, but there was a 60 per cent surge in tax-free cash withdrawals from pensions, amounting to about £18 billion. With the government signaling a potential inheritance tax on pensions from April 2027 and worries that cash withdrawals could be capped in the future, experts say some savers are taking money out now to lock in the benefit. Whether policy changes materialize remains uncertain, but the possibility is influencing decisions as people approach retirement.

How lump sums work: The minimum age to access private pensions is 55, and typically savers can take up to 25 per cent of their pension as tax-free cash, with the remainder used to secure a taxable income for the rest of life. You do not have to take the tax-free lump sum when you first access your pension, nor do you have to take it all at once. The rules vary by pension type, which affects how much you can take tax-free. Importantly, taking a tax-free lump sum does not change your income tax position, nor does it affect your personal allowance or push you into a higher tax bracket. The 25 per cent tax-free lump sum is currently capped at £268,275, though more may be available if you had fixed protection related to the old lifetime allowance. Fixed protection is complex, and those who might have it should seek professional advice to avoid costly errors.

Defined contribution pensions, which involve money contributed by both employers and employees that is invested for retirement, allow over-55s to take 25 per cent tax-free upfront, or withdraw it gradually. If the full lump sum is not withdrawn at once, more tax-free cash may be taken later. The lump sum can be taken and income drawn later, but you cannot take a taxable income without accessing some of the lump sum. Former Pensions Minister Steve Webb, now a partner at LCP, outlines four main options: cash out the whole pension with 25 per cent tax-free and pay income tax on the rest; take 25 per cent and use the remainder to buy a guaranteed income for life (an annuity); take 25 per cent and leave the rest invested with taxable withdrawals later; or leave the pot invested and take lump sums that are 25 per cent tax-free with 75 per cent taxed. Webb adds that if you cash out the whole pot, it’s prudent to avoid leaving idle funds in a current account and consider moving the tax-free portion into a tax-advantaged ISA to benefit from potential investment growth.

Final salary, or defined benefit, pensions provide a guaranteed lifetime income and remain in use in many traditional schemes, though most public-sector jobs have moved to defined contribution arrangements. If you have a defined benefit pension, the availability and size of a 25 per cent lump sum depend on the specific scheme’s terms and the minimum pension age set by that scheme. Webb notes that in some schemes the lump sum is take-it-or-leave-it, while others allow a combination of lump sum and regular pension payments up to the overall 25 per cent limit. Some schemes require giving up a substantial portion of future pension for each pound of lump sum, so careful checking is essential before deciding how much to take upfront.

If you hold multiple pensions, you do not have to take the 25 per cent from all at once. Withdrawals can be staggered across schemes, taking the lump sum from the most favorable pots and the higher pension from others. For defined contribution pots, you might take the lump sum from one scheme and use a different approach for another. If you hold several defined benefit pensions, you could take more from those with more generous terms while prioritizing higher pension from others.

What are the pitfalls? The minimum age to access private pensions will rise from 55 to 57 on 6 April 2028, so those in their late 40s and early 50s should plan ahead. Some may still access funds at 55 depending on their scheme rules, but moving pensions could cost future access rights. The annual allowance trap also looms: once you start tapping into a defined contribution pot beyond the 25 per cent tax-free lump sum, the annual allowance for contributions—known as the money purchase annual allowance—limits how much you can contribute each year with tax relief, currently set at £10,000. Taking out more than the lump sum to trigger this limit risks being charged up to 55 per cent on the withdrawal and is designed to deter pension recycling, where tax-free withdrawals are re-contributed to gain more tax relief. If HMRC determines that such recycling was intentional, penalties can be severe. Given these rules, analysts stress caution with any pre-Budget withdrawals that might be reversed later.

Inheritance tax is another factor: the government has announced that pensions will become liable for inheritance tax like other assets starting in April 2027, to prevent pensions from being used primarily to pass wealth to heirs. Some savers may choose to take a lump sum now to gift it in a manner that avoids inheritance tax if they survive seven years, but this calculus varies by individual circumstances.

Take it, or wait? Market-watchers and advisers urge pension savers to think carefully before making major withdrawals. If funds are invested well, they can grow, and taking cash now may reduce future retirement income. Andrew King, a retirement specialist at Evelyn Partners, cautions savers to think twice before making large withdrawals in anticipation of possible policy changes that may not materialize. He notes that unwarranted withdrawals can incur tax charges, remove funds from favorable tax treatment, and potentially reduce living standards in retirement, especially if investments are sold during market downturns. Steve Hitchiner, chair of the Society of Pension Professionals tax group, adds that budget speculation is often inaccurate and should not be the sole basis for major financial decisions, warning that even with potential changes, transitional protections are likely in place.

If changes do occur, experts say they would more likely cap the maximum tax-free amount than abolish it entirely. While the precise new limit is unknown, a drop below £100,000 would be a major shift. Pension experts advise against cashing out unless there is a clear, near-term need for the funds. For those who do proceed, using the funds to clear high-interest debt or to fund a specific retirement goal—such as home improvements or a long-planned trip—may be reasonable, provided the decision is well-timed and considered as part of a broader retirement plan.

Where should the money go? If you do not plan to spend the lump sum soon, investing the tax-free portion in a stocks and shares ISA can offer potential ongoing growth free of further tax. A high-interest cash ISA is another option to shield savings from tax, though the liquidity and interest rate environment should be weighed. As a rule, the annual ISA allowance is £20,000 per tax year, and savers should consider moving funds into an ISA up to this limit each year while ensuring the remaining amount is not sitting in a low-yield current account or savings vehicle. For longer horizons, other investment accounts can provide growth potential while keeping within the tax framework.