Pension savers were in an “unprecedented rush” to take their tax-free cash last year, driven by Budget rumours and inheritance tax changes – but some may be left with retirement regret.
Tax-free withdrawals surged to £18 billion in 2024/25, up from £11 billion the year before, according to FCA data obtained by wealth management firm Evelyn Partners. This constituted a 61% increase.
The second half of the tax year was busier than the first, with almost six-tenths of the total being drawn between September and March – an increase of 72% compared to the same period the year before.
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“But the fact that withdrawals were already surging rapidly in the summer of 2024, and the sheer volume since then, suggests strongly that there is another factor at play – the fear that the government would cut tax-free cash in some way at the last Budget, and that it might still do so at the next.”
Withdrawing their lump sum last year may have been the right decision for some savers – for example, those who took the money for a specific use – but others may now be left with regret.
What to consider before taking tax-free cash
Before taking tax-free cash from your pension, you need to have a plan. Are you looking to take it all in one go, what will you use the money for, and where are you planning to store it? It is also important to weigh up looming inheritance tax changes against other considerations.
1. Should you take the cash as a lump sum or instalments?
You are entitled to take up to 25% of your pension as tax-free cash once you turn 55, up to a maximum of £268,275 (known as the lump sum allowance). While some choose to take the cash in one go, others take it in instalments. If you take it in instalments, 25% of each withdrawal will be tax-free.
One of the benefits of taking the money in instalments is that the majority remains invested. If your pension pot increases in value, the tax-free portion will increase in value too.
It is worth bearing in mind that this approach does trigger something called the money purchase annual allowance, which might not be ideal if you are still working and paying into your pot. More on that below.
2. Do you have a plan for the money?
If you don’t have a plan for your pension tax-free cash, you might want to leave it invested in your pension, where it will hopefully continue to grow. While held within the pension wrapper, it is shielded from income and capital gains tax.
Even if you do have a plan, it is worth getting personalised guidance or advice before drawing from your pot. The free Pension Wise service from MoneyHelper, which is backed by the government, is a good first port of call.
A priority for many people is using their lump sum to pay off their mortgage. It is perhaps unsurprising – the thought of managing large monthly repayments once your workplace salary has stopped is daunting.
According to financial services company SunLife, one in seven people over the age of 50 still have a mortgage, with the average monthly repayment coming to £887.
Even so, there are other considerations. How much interest are you paying on your mortgage? If the growth rate achieved by your pension is higher than the interest rate on your mortgage, you might be better off leaving the money invested in your pension.
You also need to consider the terms and conditions on your mortgage. Will using the tax-free cash to repay it trigger an early repayment charge?
Most mortgage lenders only allow you to overpay your mortgage by 10% each year. If you want to pay more than this without incurring a charge, you may need to wait until your current deal comes to an end.
3. Where will you store the cash?
Before taking tax-free cash from your pension, you need to think carefully about where to store it.
A survey conducted by Hargreaves Lansdown last year found that one in four are undecided on how to use their tax-free cash, suggesting they may end up sticking it in a low-yielding savings account where it is exposed to inflation.
“You need to be careful,” said Helen Morrissey, head of retirement analysis at the investment platform. “It is really important that large amounts of money are not kept in accounts paying out poor levels of interest long term, because inflation will erode its spending power over time, whereas it has more potential for growth if kept in the pension wrapper.”
Hargreaves Lansdown generally recommends that retirees keep enough cash in an easy-access account to cover one to three years worth of essential costs – an emergency fund of sorts. Any more than this, and the funds could be better used elsewhere.
There are also tax implications when keeping large piles of cash in a savings account. Most basic-rate taxpayers have to start paying income tax on their savings interest once they earn more than £1,000. For higher-rate taxpayers, this falls to £500, while additional-rate taxpayers do not have any personal savings allowance at all.
3. If you dip into your pension pot again, there are tax implications
Once you have spent your tax-free cash, dipping back into your pension pot has significant tax implications. Each subsequent withdrawal is subject to income tax, paid at your marginal rate.
Furthermore, drawing taxable income from your pension generally triggers something called the money purchase annual allowance. Once you have triggered this, you only get tax relief on contributions worth up to £10,000 a year, down from £60,000 previously. This can be a problem if you are still working and contributing to your pension.
4. Are you really reducing your overall tax liability?
Upcoming inheritance tax changes have been a big driver of pension withdrawals, with some savers nervous about the prospect of double taxation. From April 2027, inherited pension pots will be subject to 40% inheritance tax, plus income tax once the beneficiary starts to withdraw the money.
This is influencing saver behaviour, with some people dipping into their pensions to give away money to loved ones before they die. This comes with risks. Firstly, nobody knows how long they will live and how much money they will need to pay for things like care. Secondly, failing to outlive the gift by seven years will mean it is subject to inheritance tax anyway.
There is also the risk a saver could die before the inheritance tax changes kick in. Sterland said: “While it is not pleasant to think about, if someone withdraws their tax free cash now – when it is still exempt from IHT while it sits in the pension – and then dies before April 2027, they will have taken their funds from an IHT-free environment to a taxable one, as the money will enter their estate for IHT purposes, even if they gift it.”
Finally, gifting money out of your tax-free lump sum will leave you more reliant on the taxable portion of your pension when covering your living expenses later on in retirement. You need to think about your own income tax liability, not just the inheritance tax your family might end up paying further down the line.
What to do if you made a panicked withdrawal before the Budget
If you withdrew your tax-free lump sum last year in response to Budget rumours, don’t panic. It wasn’t necessarily the wrong decision, provided you had a carefully-thought-out plan for how to use it.
If you took it without making a plan, you may have felt a stronger sense of regret when the rumoured policy never materialised, and the 25% tax-free cash remained in place.
“If you have a large sum of cash that was taken from a pension and is now sitting in a taxable environment, then you should take action,” said Jason Hollands, managing director at Evelyn Partners.
“Steps to consider include maximising ISA allowances of up to £20,000 per adult and, if you are married, then consider moving the cash into the name of your spouse, if they are subject to a lower rate of tax than yourself.”
Certain UK government bonds could be another option, given the tax characteristics. If you don’t need immediate access to the funds, Hollands suggests looking at short-dated gilts – i.e. those due to mature in the next few years.
He said: “Numerous gilts are currently trading at prices below the value they will be redeemed at, offering very predictable returns which are also very tax efficient versus savings interest, as price gains from gilts are exempt from capital gains tax.”
Should you listen to 2025 Budget rumours?
Taxes are expected to rise this Autumn as chancellor Rachel Reeves looks for a way to balance the books. Every time money needs to be raised, there is speculation about whether the government will trim the tax-free cash allowance. However, as last year’s Budget shows, savers should be careful to avoid knee-jerk reactions.
The Telegraph recently said Reeves was considering the measure as part of an extensive list of money-raising proposals, but its report also cited a Whitehall official who reportedly called reforms “unlikely”. This suggests any rumours this time around could be shaky.
As Hollands, from Evelyn Partners, points out, savers who panicked last year are now “exposed to tax on interest and dividends outside of the pension”. They also “missed out on the strong returns we have seen from the stock market over the last year”.
Panicking this time around could produce the same result. It is usually better to base your actions on confirmed policies rather than responding to rumours.
