Should a 25% tax-free pension be taken as a lump sum or as installments?

A 25 percent tax-free lump sum withdrawal from your pension may seem like a good idea, but it may not be the best strategy for managing your retirement funds

One of the primary draws of private pensions for many savers is the opportunity to receive a tax-free lump sum of 25% of their pension savings upon retirement.

You can use this money for a variety of purposes, such as paying off a mortgage, supporting grown children, or taking a trip, but you don't have to use it all at once. In fact, it might be more sensible to choose installments.

For starters, funds that remain in your pension fund can be reinvested. You immediately diminish the value of your pension pot and eliminate the opportunity for it to increase in value if you take out 25% of your pension savings.

Furthermore, keeping some of those savings invested could mean they benefit from any future recovery and improve your overall situation if the volatile investment markets have decreased the value of your pension.

Additionally, you can use your tax-free money to augment your pension income by receiving it in installments as opposed to all at once. Younger savers awaiting the start of state pension benefits, for instance, or anyone worried about making ends meet, might find this helpful.

Money taken out of your pension is regarded as part of your estate for inheritance tax (IHT) purposes, which is another advantage of staggering your tax-free cash.

On the other hand, you can usually pass on savings in a pension plan to your heirs without worrying about an IHT liability. That could be extremely valuable if your family is worried about the inheritance tax bill.

However, in 2027, the laws pertaining to IHT and pensions will be altered. Chancellor Rachel Reeves announced plans to include unused pensions and some death benefits in the value of an individual's estate for inheritance tax purposes in her Autumn 2024 Budget statement. Starting on April 6, 2027, this rule change will go into effect.

How to arrange your pension: taking a lump sum payment in installments.

There are several methods to arrange your pension income if you intend to take your tax-free pension lump sum in installments. The majority of savers will find it prudent to seek independent financial advice on the best course of action.

To leave your pension uncrystallized is the easiest option. In other words, instead of planning withdrawals through an income-drawdown plan or an annuity purchase, you will take money straight out of your savings.

You will only have to pay income tax on the remaining 75% of the fund each time you take a withdrawal because 25% of it will be covered by your right to withdraw 25% of the fund tax-free.

Alternatively, you can use a more traditional drawdown arrangement, called flexi-access drawdown in technical terms, but stagger the transfer of your savings into the plan. You withdraw a tax-free lump sum from your remaining pension fund whenever you need money from your savings.

The next step is to move three into the drawdown plan for every one taken. Only when you take this money out of the fund will you have to pay taxes on it. You can continue doing this until all of the money in your initial pension plan has been used.

Does taking my tax-free pension lump sum in installments make sense?

Each of these options for receiving your tax-free pension lump sum in installments has advantages and disadvantages. Your unique situation will determine which course of action is best for you.

In any case, there's a good chance that you'll end up with more tax-free money than you would have if you had taken the full 25 percent entitlement up front. The cash value of the tax-free part of your pension fund will increase if it keeps growing.

But keep in mind that declining your upfront tax-free money might be a luxury you cannot afford. You will need to take the full 25% lump sum or alter your plans if it was included in your financial planning as you enter retirement. However, there are significant benefits to paying in installments if you can afford to forgo the entire lump sum at once.

Is a lump sum payment from a tax-free pension considered income?

No, there are no taxes.

But the remaining 75% of your pension fund will be subject to income tax. Your income tax band for that year determines how much tax you pay.

Before your drawdown income payment is distributed, your pension provider will deduct any applicable taxes.

How to withdraw a lump sum payment from a pension that is tax-free.

This practical aspect of things can be handled by your financial advisor if you have one.

You can talk to your pension provider directly about getting your money if you're managing your retirement plans on your own.

"There are UFPLS uncrystallized funds pension lump sums for defined contribution plans," explains Laith Khalaf, AJ Bell's head of investment analysis.

25% of this cash withdrawal from your pension plan is tax-free, while the remaining amount remains unchanged.

As an alternative, you can purchase an annuity and withdraw your twenty-five percent now. Or take advantage of income drawdown, which allows you to withdraw all or a portion of your tax-free funds while keeping the remainder invested. Another option is to combine the two.

Regardless of your choice, your provider will explain what you must do, which may be as easy as completing an online form. The procedure will differ depending on the provider. Keep in mind that you can only do this after you turn 55 (or 57 starting in April 2028).

Final salary plans, sometimes referred to as defined benefit plans, usually provide a predetermined lump sum payment that is tax-free in addition to a scheme pension, which is a predetermined income for life.

According to Khalaf, the payment would only be automatically triggered when the scheme's retirement age is reached. With a lower income, you might be able to start receiving your pension earlier if you retire before this date.

In contrast, some plans might allow you to continue accruing benefits after you reach the scheme's retirement age if you choose to retire later. "You should talk to the department in charge of the pension plan."

What is the tax-free amount I can withdraw from my pension?

Generally, up to 25% of your total pension savings are tax-free.

The maximum you can take is 268,275, but if you have a protected allowance, your tax-free amount might be higher. The majority of savers will not be impacted by these limits, which only apply to those with pension funds exceeding £1 million. According to PensionBee, the average pension pot in the UK is approximately 20,000.

The 25 percent limit has some exceptions. With certain traditional workplace pensions that offer protected tax-free funds, you may be able to withdraw more than 25%. This is something you will need to discuss with your scheme provider.

If you are near death, you might be eligible to receive your entire pension as a tax-free lump sum. To qualify, you must be under 75, have a serious illness that would cause you to die within a year, and have a payout that is less than your lump sum and death benefit allowance.

Does this threaten the 25 percent tax-free lump sum pension?

Given how valuable this pension benefit is, there is frequently discussion about changing or eliminating it completely.

Prior to Labour's first Budget in October 2024, there were most recently rumors that the pension tax-free lump sum was in danger.

It is crucial to keep in mind that tax laws and allowances are subject to change and should be utilized to the fullest while they are available.

Avoid falling for pension scams.

Fraudsters frequently target those who intend to take money out of their pension, so be cautious of cold callers who offer their services. Cold callers who claim to be aware of loopholes that could enable you to receive more than the customary 25% of your pension pot tax-free are examples of scams. They may try to get you to give them your pension as part of this scam, which could result in the instant loss of your entire life savings.

Many scammers duplicate the websites of legitimate pension companies and steal money by posing as employees of those companies and promising to manage their pension funds.

They may also guarantee that you will be able to access your pension funds prior to turning 55.

Cold calling regarding pensions has been prohibited since January 2019, so unless you specifically asked someone to call you, any caller is probably a scammer.

Never be forced to make a decision; if someone tries to pressure you into agreeing to something too quickly, your suspicions should be raised.

Spend some time planning your pension and, if required, seek the advice of a qualified advisor. On Unbiased.com, you can locate one nearby.