Tax-free lump sum questions: answered

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We regularly run free retirement webinars, where those attending can put their burning questions to a panel of experts. We’ve been getting a lot of questions about tax-free lump sums – so retirement expert Scott McQueston is back to answer the most popular ones.

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First, what is a tax-free lump sum?

It’s the amount you’re allowed to take tax-free from your pension savings once you reach the minimum pension age – it’s one of the main benefits of a pension plan. Most people will be able to take 25% of their pension pot tax-free and will pay income tax on the remaining 75% of their pot.

So, Scott, do you have to take all of your tax-free lump sum in one go?

No, most people won’t need to take their entire tax-free amount in one lump sum. You can usually take as much or as little as you want to, as long as your provider has the pension product needed to facilitate this. If you have a product with us, you’ll be able to do this.

If you have more than one pension plan, do you get 25% tax-free on every plan you have?

For defined contribution pension plans, like the ones you get at Standard Life, you’ll be able to take 25% tax-free from each of these plans. This is subject to the lifetime allowance limit, which is currently £1,073,100 – unless you have lifetime allowance protection for a higher amount. 

If you’re not sure if you have lifetime allowance protection, you can get in touch with your financial adviser or contact HMRC. If you give them your National Insurance number, they’ll be able to tell you.

Is there a limit to how much you can take as a tax-free lump sum?

You’ll normally only get 25% of the value of your plan tax-free, and you’ll never get more than a quarter of your lifetime allowance (£268,275 unless you have lifetime allowance protection for a higher amount). This is still the case even though the lifetime allowance tax charge was done away with in the Spring Budget.

However, some people who have older-style occupational pension plans may have a protected tax-free entitlement, which would be higher than the usual 25%. You can check this with your pension provider if you’re not sure.

Can you choose to take just taxable money before you’ve taken all of your tax-free lump sum?

Yes, if you choose to take your pension money as a flexible income (drawdown) and your pension provider allows this. But you’ll need to have enough in your ‘drawdown pot’ for any taxable income you want to take – I’ll explain what this means. 

Let’s say one of our customers has £100,000 in their pension plan. They’ve turned 55 (keep in mind the minimum pension age is going up to 57 from 6 April 2028) and they want to go on a big family holiday and plan to use some of their tax-free amount to pay for it. They might take £10,000 as a tax-free lump sum. 

For every £1 of your tax-free lump sum, there’s £3 that you’re going to need to pay income tax on. So we earmark it by moving those £3 from your ‘savings pot’ (where the money you pay into your plan goes) into your ‘drawdown pot’ – they’re also often called your pre and post-pension pots or your uncrystallised and crystallised pots.

So, in this example, the customer takes £10,000 and gets that in their bank account. Then £30,000 gets moved from their savings pot to their drawdown pot, ready to pay income tax on when they take it. They’ve now got £60,000 left in their savings pot, which leaves £15,000 of their tax-free lump sum left to take, depending on how their investments perform.

It sounds quite complicated, but if you want to learn more about how the different pots work, you can read What is pension drawdown?

I always use my mum as a good example for why taking some taxable income instead of a tax-free lump sum could work for some people. She doesn't earn anymore, and her mortgage is paid off. She has some of her tax-free lump sum left, but she has some money in her drawdown pot as well.

My mum doesn’t want to use up her tax-free lump sum until she really needs to. She doesn’t need much to fund her lifestyle, and she's got £12,570 of ‘taxable’ income that she could take and not pay any tax because it’s her personal allowance for the year.

Can you take tax-free money and taxable money at the same time?

Yes, as long as your pension provider can support this. At Standard Life, you can choose an option called tailored drawdown where you take a bit of both at the same time. This can be a more tax-efficient way of taking your money. 

So could you take £1,000 as a tax-free lump sum and £1,000 of taxable income each month and all of it would be tax-free?

Sometimes, yes – but it depends on your tax code.

Your first taxable withdrawal is usually going to be emergency taxed. After that, HMRC will give us a tax code which we’ll apply from then on – and it can constantly change. So, for example, you might get emergency taxed on the first taxable withdrawal you take – maybe up to 40 or 45% – but you’ll sometimes get that back on your next withdrawal.

After that, HMRC will keep giving us a tax code through a system called ‘real-time information’ – so it’s just like if you were employed. If HMRC didn't have your P45 from your last job, your first wages from your new job would probably get emergency taxed. But once your employer gets the correct tax code from HMRC, they just apply it from then on.

If the updated tax code shows that you can take £1,000 of income a month from your plan and not pay income tax on it, then you wouldn’t pay tax on either of the £1,000 payments. 

You can find out more about the tax you pay on pension withdrawals in How much tax will I pay on my pension withdrawals?

If you take a tax–free lump sum, does that mean the amount you can pay into your plan will be less?

No, taking a tax-free lump sum alone will not trigger the money purchase annual allowance (currently £10,000 a year). 

For example, we have a lot of customers who come to us and they want to take a big chunk of their tax-free sum to pay off their mortgage. But they might still work for many years and want to continue to pay into their pension plan. Taking that tax-free lump sum won’t lower the amount they can pay in.

The information here is based on our understanding in July 2023 and shouldn’t be taken as financial advice.

A pension is an investment and its value can go down as well as up and may be worth less than was paid in.

Your own personal circumstances, including where you live in the UK, will have an impact on the tax you pay. Laws and tax rules may change in the future.

Standard Life accepts no responsibility for information in external websites. These are provided for general information.