Senior couple clinking champagne on a yacht deck

Should you take a tax-free lump sum from your pension to celebrate retirement in style?

What are your plans for your first few years of retirement? Being able to take a tax-free lump sum from your pension can open up a whole host of possibilities. But would you be better off leaving your money invested?

When Pension Freedoms were introduced in 2015, it gave retirees more flexibility. One of the benefits introduced was the ability to take up to 25% of your pension without paying Income Tax on it once you reach 55, rising to 57 in 2028. It’s certainly an attractive option and can mean you have the cash to turn your retirement dreams into a reality. From undertaking home renovations to travelling the world, you could start your retirement in the style you want by taking a lump sum.

It’s an option that proved popular among retirees. While it can be tempting to take the money on offer, there are a couple of questions to consider first.

1. What do you plan to do with the money?

The first thing to think about is what you would do with the money if you did take the tax-free lump sum.

Whether you want to book a once in a lifetime trip or lend a helping hand to family members, setting out where the money will go can help you understand if it’s something you want to pursue. In some cases, there may be alternative ways to fund your plans, allowing you to leave your pension untouched.

Some people take their tax-free lump sum without any plans to use the money. It can be tempting to take the lump sum simply because it’s available to save for a rainy day. However, adding a lump sum to a savings account means it’s likely to lose value in real terms. Interest rates are lower than inflation, so the spending power of the money will decrease over time.

You may also consider withdrawing the money to invest it. However, keep in mind that your pension is usually invested and is a tax-efficient way to save for retirement.

2. How will it affect your long-term income?

While you may be thinking about kickstarting retirement by ticking off bucket list items by using your tax-free lump sum, you need to look at the bigger picture too. You save into a pension to create an income throughout retirement, not just those first few years.

Taking a quarter of your pension to spend from the outset can have a huge impact on the income your pension will deliver for the rest of your life. As a result, it’s important to consider the pension lump sum in the context of your wider retirement plans and ask questions like:

  • How long does my pension income need to last?
  • What income do I need throughout retirement?
  • Do I have a buffer in case of the unexpected?

It can be difficult to understand how taking a lump sum now could affect your income in 20 years. Financial planning can help you weigh up the long-term impact of the decisions you make now. In many cases, clients find they can afford to pay for retirement goals and have financial security, but reviewing your financial plan before you take a lump sum out of your pension means you can have confidence and fully enjoy the experiences you’re looking forward to.

Taking your tax-free lump sum at 55 isn’t your only option

You don’t have to take your tax-free lump sum as soon as you reach retirement age to use it.

You can leave your pension untouched and take the tax-free lump sum at a date that makes sense for you. This way, your pension remains invested and has the potential to continue growing. While you can access your pension at 55, you may not be ready to retire for a decade or more. An extra 10 years of investment returns on the lump sum you could have withdrawn can have a real impact on the size of your pension when you retire.

What’s more, you can spread out the tax-free benefit too. Rather than taking a single tax-free lump sum, you can withdraw multiple lump sums, of which 25% of each is tax-free. For some, this can help manage your tax liability and ensure your income suits your needs.

So, there’s one than one way to take advantage of the tax-free lump sum when accessing your pension. If you’re thinking about making a withdrawal from your pension and you’d like to discuss which option makes sense with your retirement goals in mind, please contact us.

Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available.

Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation, which are subject to change in the future.