Why taking your pension tax-free lump sum could leave you thousands of pounds worse off

Getting a tax-free lump sum is one of the biggest perks of paying into a pension.

Savers typically use their 25 per cent tax-free cash to clear remaining mortgages, splash out on new cars, home renovations and trips abroad or even to ease the strain of day-to-day living costs.

But not everyone should rush to cash in when they reach their mid 50s. Withdrawing the money too soon could leave you thousands of pounds worse off in the long-run.

Currently, those over the age of 55 (rising to 57 from 2028) can take 25 per cent of their pension pot tax-free up to a £268,275 cap.

Savers withdrew a colossal £3.9 billion in pension lump sums in the 12 months to October, according to official figures — up 81pc compared to the same period in 2022/23.

The withdrawals surged ahead of the 2025 Autumn Budget amid rumours that the Labour government was poised to slash the perk.

Around 116,000 people withdrew a pension lump sum as soon as they could at age 55 last year, taking a combined £2.3 billion from their pots, according to wealth manager Lubbock Fine Wealth Management.

That’s up from 84,200 savers aged 55 who withdrew £1.7 billion five years prior in the 2020/21 tax year.

But taking money from your pension should not be done lightly – it can have significant implications for the future.

Andrew Tricker, a financial planner at Lubbock Fine, says: ‘It is worrying that more people are tapping their pension pots so long before the usual retirement age.

Some are taking too much, too soon. Without careful planning, they could find themselves short of money in retirement.’

Many savers take their tax-free lump sum without a clear plan for what to do with the money.

Keeping cash in the bank often feels like a safe and easy option – but that’s not necessarily the case. Money taken out of a pension loses its ability to keep growing tax-free and tends to be stashed in savings accounts on which growth will be taxed.

Savers are also likely to find it harder to grow their money and keep up with inflation.

For example, someone with a £400,000 pension pot who withdraws 25 per cent as a tax-free lump sum (£100,000) and leaves it in a savings account earning 3 per cent interest a year, would have about £134,000 by the time they retired ten years later, according to calculations by wealth manager Broadstone.

If their remaining pension pot kept growing at 5 per cent a year, after ten years it would have reached £448,688, giving them a combined value of £582,688.

However, if they had left their entire £400,000 pension pot to keep growing until age 65 without taking any tax-free cash, it could reach £651,558 — an extra £68,870.

They would now also be able to withdraw a considerably larger 25 per cent tax-free lump sum of £162,889.

Robert Cochran, pensions expert at Scottish Widows, says that a loss of investment income is not the only downside of moving the money into cash.

If the lump sum is left in the bank, for example, savers are at a high risk of receiving a tax bill. This is because they can easily breach their personal savings allowance, which is the amount of interest they can earn before paying tax. Basic-rate taxpayers can earn their first £1,000 in ordinary, non-Isa savings accounts without paying tax.

Everything above that is taxed at their income tax rate of 20 per cent.

Higher-rate payers get a £500 allowance while additional 45 per cent payers get no allowance at all.

Money in the bank may also struggle to keep pace with inflation, meaning it loses value in real terms. This is because easy-access savings accounts typically pay less than inflation at the moment.

Kelly Parsons, from Broadstone, says: ‘The difference really does compound over time and can make a tangible difference to your standard of living in retirement.’

Some 42 per cent of savers plan to take their full tax-free lump sum in one go, according to research by pension provider Standard Life. Many view it as a good way to start their retirement journey, a survey has found.

But there is another option that could leave you better off in the long-term.

Savers can draw from their pension flexibly, taking as much as they need, as and when they need it. When they do this, 25 per cent of every withdrawal is tax-free instead, with the rest liable for your usual rate of income tax.

On a £10,000 withdrawal, for example, £2,500 would be tax-free and the rest at your usual rate of income tax. This approach can be particularly effective for those who are still working as it is easier to make the withdrawals tax efficient, keeping below income tax thresholds.

Cochran says: ‘Spreading your tax-free cash across the years can help you manage your income tax.’

Flexible drawdown can help a pot last longer, too. Leaving more money invested to grow can mean you end up withdrawing more over the long-term. This is particularly important for those who want to make sure their money lasts for the rest of their life, and those worried about potential care fees in later life.

For example, take a 55-year-old with a £400,000 pot who withdraws their full tax-free lump sum, leaving the remaining £300,000 invested.

Let’s assume this grows at 5 per cent a year, and the saver withdraws £20,000 a year from the pot. After 20 years, they have withdrawn a total of £500,000 and have £180,000 left invested — total pension benefits of £680,000.

Alternatively, they could leave the full £400,000 invested and use ‘flexi-access’ drawdown to take £20,000 a year, with £5,000 of each withdrawal tax free. After 20 years, they will have withdrawn £400,000 and have £310,000 left invested — total pension benefits of £710,000.

The best option for you will depend on whether you need the money in the short-term, and what your long-term plans are. Parsons says: ‘This strategy can really help with growth and reduce the amount held in cash unnecessarily early in retirement. It may seem a small decision at the outset but it can have a surprisingly large impact over a 20- or 30-year retirement.’

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Suddenly coming into a windfall can skew your finances and mean you miss out on other crucial payments.

It could, for example, affect your entitlement to means-tested benefits like Pension Credit. Those aged 66 and over, with a weekly income below £238, can qualify for this payment and being eligible can open the door to other help, such as a free TV licence and the winter fuel payment.

But having a large amount in savings can affect your entitlement as it’s counted towards your available income. This typically affects those with more than £10,000 in savings. Every £500 in savings above this amount counts as an additional £1 income per week, HMRC says.

Another big tax trap to watch out for is the so-called ‘Money Purchase Annual Allowance’ (MPAA), although this typically kicks in when savers make pension withdrawals beyond the tax-free lump sum.

If you take a penny more than your tax-free lump sum, the MPAA slashes the maximum you can contribute to a pension drop from £60,000 to £10,000 a year.

This could be a major problem for those who are still working and paying into their pension. According to figures from the Financial Conduct Authority, the City regulator, at least 54pc of those who accessed a pension for the first time in 2024/25 did so in a way that could trigger the MPAA.

Parsons says: ‘These rules really underline the importance of understanding the wider impact that pension withdrawals can have before making any decisions.’

There are plenty of good reasons to withdraw your tax-free lump sum, whether it’s clearing the mortgage, helping children through university or onto the property ladder, or just covering day-to-day costs as you transition from full-time to part-time work before retiring.

But money within a pension enjoys generous protections, including the ability to keep growing tax-free, so it is important to have a clear plan.

‘The tax-free lump sum is a valuable option but it shouldn’t be a default decision,’ says Parsons. ‘It’s important to understand how and when to use it, and the trade-offs.’

Those leaving any of the cash in the bank, even for a short period, should find the best savings rates and make use of their cash Isa allowance to avoid a tax bill on savings interest.

Cochran says: ‘This is complex stuff and getting professional advice could save you a lot of tax in the long run. Ultimately, don’t just take your tax-free cash because you can — only take it if you need it.’