Pension lump sums: a guide to the essentials

Pension lump sums  – also known as pension commencement lump sums (PCLS) – are common to all kinds of pension schemes but are frequently misunderstood.

For example, did you know that in many cases, you don’t have to take a lump sum in just one lump?

Are you aware that with careful planning and expert help, you can use a lump sum to retire earlier than you may have thought possible?

And did you know that your lump sum can actually grow even after you retire?

Here we take a look at the essentials of the pension lump sum and outline how it can be one of your most effective paths to a fulfilling retirement.

What is a pension lump sum?

A pension lump sum refers to the amount of money which you can take from a pension that is tax-free.

At the current moment in time, up to 25% of the amount you have saved in a pension fund can be taken tax-free. This is unless you benefit from safeguarded benefits such as protected tax-free cash, in which case it may be more.

When can I access my pension commencement lump sum?

As of the time of writing, you can access anything up to the full 25% of your pension as a lump sum from the age of 55. This will increase to the age of 57 by 2028.

Do different types of pension treat lump sums differently?

In the main, yes. If you have a defined contribution pension – where you (and potentially your employer) put in contributions to build up a pot of money – then you are free to access your lump sum as you like.

If you have a defined benefit pension (also known as a ‘final salary’ pension) then there is normally less freedom when it comes to your lump sum.

Defined benefit schemes give a guaranteed monthly sum upon retirement. Normally they offer pension holders a choice between a larger lump sum and a smaller monthly payment or a smaller lump sum and a larger monthly payment.

Do I have to take my lump sum in one go?

Defined benefit schemes usually offer lump sums only in one payment.

However, defined contribution schemes are more flexible.

You don’t have to take your 25% tax-free lump sum all at once. It is possible to take it in whatever stages you like – in a series of monthly sums, quarterly payments or annual payments. You can also start drawing on it and then either increase, decrease or pause withdrawals according to your specific circumstances.

Also, you can decide to take a large sum at the start for things such as paying off debts or buying a once in a lifetime holiday. You could also do that that after a few years, providing you haven’t exceeded your 25% tax-free allowance.

Do I have to retire after I take a pension lump sum?

No. If you want to, you can keep working after taking a lump sum, even working full-time.

As a result, your lump sum or part of it could be used for things such as paying off your mortgage or financing your children through university.

You could also use money from your lump sum to start working part-time, taking regular monthly draw-downs to supplement your part-time income.

Can a lump sum help me retire earlier?

Yes! You can use money from your pension lump sum to provide a regular income before you reach State pension age.

For example, if you have built up a £250,000 pension pot, you can take £62,500 as a lump sum.

You could take that money aged 64 and use it to give yourself a monthly income of over £1,730 until you reach the current State pension age of 67.

How much tax will I pay on my pension lump sum?

While the pension commencement lump sum itself cannot be taxed, even as a pensioner, any other income will still be subject to tax.

Anything you earn above the personal tax allowance of £12,570 a year will still be subject to income tax at 20%, rising to 40% at £50,271 a year.

This is just one of the reasons why getting expert advice from a qualified financial adviser is so important.

Your adviser can show different scenarios to work out the best way to use your pension lump sum to achieve your life goals.

The adviser can also show you how best to combine your lump sum with other pension savings to finance your retirement.

Should I put my lump sum into savings?

Generally speaking, it is best to keep your lump sum within your pension fund as long as you can.

Unless your lump sum is small, withdrawing it to put the money into savings could mean you end up paying tax on those savings.

While putting the lump sum into a cash ISA will avoid tax, the interest rate paid could be lower than inflation. This would eat away at the value of your lump sum over time.

Keeping all or part of your lump sum within your pension fund will shelter it from tax. Depending on the performance of your investments, you could also see your lump sum grow, even if you have already taken out some of it.

Do lump sums attract inheritance tax?

Previously, pensions were not subject to inheritance tax. This is one of the reasons why we advised clients to keep their lump sums for as long as possible.

However, from April 2027, all unused pensions, including lump sums, will count towards the value of an estate.

In addition, if you die after age 75, your beneficiaries will pay income tax on money from your pension.

This makes keeping a lump sum after the age of 75 questionable since you will be effectively passing on a tax liability.

This is another reason why getting expert advice on your pension is so important.

Key takeaways

A pension lump sum is a key part of your financial arsenal when it comes to later life planning.

Used well and with the help of expert advice, a lump sum can help you achieve a host of life goals.

To find out more about how a lump sum could help you, get in touch with one of our advisers today.

Disclaimer: This article is for informational purposes only and does not constitute financial, tax, or legal advice. Tax treatment depends on individual circumstances and may change. Always seek professional advice before making financial decisions. It is important to note that the value of investments and the income from them can go down as well as up and that you may get back less than the amount you invested.