Tax-free pension lump sums: don’t make a pre-Budget snap decision

As the Autumn Budget approaches, speculation around potential changes to pension tax policy has resurfaced, particularly regarding the future of the tax-free lump sum.

Several newspapers have run articles questioning whether Chancellor Rachel Reeves is targeting a tax raid on lump sums to raise funds for the Treasury this November.

We look at whether this is likely to happen and what lessons can be learned from what is becoming something of an annual event.

What is a pension lump sum?

A pension lump sum refers to the amount of money which you can take from a pension that you do not have to pay tax on.

Under current UK pension legislation, individuals are generally entitled to access up to 25% of their pension fund tax-free, known as the Pension Commencement Lump Sum (PCLS).

When can I access my pension lump sum?

As of the time of writing, under most pension scheme arrangements, 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.

How much money can I take tax-free?

As of the time of writing, the maximum amount you can take from a pension tax-free is £268,275.

Some people who took out tax-free money from their pensions before rules changed in April 2024 can take out more than that sum under transitional protection rules.

Is this amount going to change?

None of us – apart from the Chancellor – can answer this question definitively.

Media speculation about a potential reduction in the pension tax-free lump sum has intensified in recent months.

However, such a cut would appear to go against the general direction of Government pension policy.

From the introduction of auto-enrolment onwards, Governments of both main parties have been keen to encourage people to save more for their pension and not rely so much on the State.

Cutting the tax-free lump sum would not act as an encouragement to people in their 30s and 40s to save more for their retirement.

While the Government is making unused pensions count towards inheritance tax from April 2027, that measure affects families of pension holders rather than the pension holders themselves, who would be hit if the tax-free allowance was cut.

Clearly without a crystal ball, we cannot say for certain what will happen to tax-free allowances.

However, that is even more reason not to act hastily and do something you could later regret.

What action should I take?

In situations where you fear a financial benefit could disappear, it is tempting to take action.

Nevertheless, in the case of tax-free pension lump sums, this could really backfire.

To start with, if you decided to access your tax-free allowance now (assuming you are of the age when you can) then you would be acting on rumour, rather than fact. As any investor knows, that is rarely a wise course of action.

Secondly, by cashing in your tax-free lump sum now, you could lose out of thousands of pounds worth of tax-free money in the future.

To take an example, let’s say you’re aged 55 and have a pension of £400,000. Cashing in your lump sum now, you would be able to get £100,000 tax-free.

However, assuming a growth rate of 5.78% on a medium risk level of investment, you would be missing out on a considerable amount of tax-free cash, as you can see below:

Taking tax-free money now could also mean your loved ones paying out more in inheritance tax.

If you were to die before April 2027, current rules mean your descendants don’t have to pay income tax on any money in your pension. But if you take the lump sum now, that money would become part of your estate and would be subject to inheritance tax.

On a broader point, if you have a future income plan in place for your retirement, taking a lump sum earlier will mean you having to recalibrate that plan or risk running out of money at some point in the future.

How can a financial adviser help?

It is in situations like this that taking expert advice from a financial professional before making any decisions is crucial.

A financial adviser can look at the whole picture, taking into account your individual circumstances and financial and life goals, and give you the advice which works best for you and your family.

Key takeaways

Speculation about tax changes inevitably increases in the run-up to every Budget, but making major alterations to your financial plans in response to rumours is not a good idea.

A tax-free lump sum is one of the great benefits of having a pension and you should think carefully about when and how to access it.

Getting expert financial advice can help you to make the most of your lump sum for you and your family.

Get in touch today to speak to us about how we can help.

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. The value of investments can go down as well as up and you may not get back the full amount you invested. Past performance is also not a reliable indicator of future performance. Always seek professional advice before making financial decisions.