Should I take a lump sum from my pension? 4 reasons why you should think twice

It is common for those reaching age 55 to withdraw the maximum 25 per cent tax-free cash lump sum from their pension.

Many do so in order to splurge on the holiday of a lifetime, make home improvements, pay off a mortgage or help out children or grandchildren.

However, the question should be asked: would people be better off leaving that money invested and withdrawing their pension gradually over a longer period instead?

Here are 4 instances where the answer to that question might be “yes”.

1) There is no specific purpose for the money

There is no real point in simply withdrawing the money from your pension and then depositing it into a low-interest savings account, just because you can.

Doing so will mean that your funds are going to be eroded by inflation.

In addition, if you decide to reinvest the money once you have withdrawn it from your pension, any gains or income will potentially be liable to tax.

However, if the money stays invested within your pension, both gains and income will accrue free from tax.

2) If your estate is likely to be subject to inheritance tax

With the UK inheritance tax nil rate band and residence nil rate band now frozen until 6th April 2026 at £325,000 and £175,000 respectively, more and more people are finding that there is a potential IHT liability on their estate.

Unnecessarily taking money from a pension only increases the potential IHT burden.

However, by leaving your money in a pension, it can be passed on to beneficiaries free from UK inheritance tax.

In some cases, it can make more sense to spend non-pension assets first, leaving the pension fund and tax-free cash entitlement to grow in a tax-efficient environment until it is actually needed.

3) You need or want to maximise your income in retirement

Obviously, if you take 25% as a lump sum from your SIPP or personal pension as soon as you can, then the amount of income that you can subsequently draw from that pension is going to be greatly reduced.

The same applies with a final salary/defined benefit pension. If you don’t take the lump sum then the pension income that you receive will be higher (this income will also be index-linked for the rest of your life).

4) You live in a country that taxes pension lump sum payments.

While most people use terms such as “tax-free cash” or “tax-free lump sum”, I prefer the term “Pension Commencement Lump Sum”.

This is because, when taken outside of the UK, these payments are not always tax-free.

Whether it is or not, depends on the double taxation treaty between the country that you are tax resident in when drawing the money and the UK (or if your pension is a QROPS, the country that the QROPS is registered in, e.g. Malta).

For example, in France, the concept of a Pension Commencement Lump Sum does not exist.

As a result, all pension payments are subject to French tax and social security. [There are some rather interesting pension tax mitigation tools that can be used by those resident in France. However, that is a subject for another day.]

The same applies in Sweden, where pension lump sums and pension income are taxed in the same way.

However, there are also countries, like Poland, where the tax treaty clearly states that the lump sum should be taxed in the UK, and is therefore tax-free.

Conclusion

Inevitably, the decision on whether or not to take your pension commencement lump sum/tax-free cash will depend on your personal circumstances and preferences.

As always, knowing the facts and planning intentionally is the best route to an optimal outcome.