Tax-free cash: the 25% decision

The most-anticipated part of a pension, and the one most often taken too early.

A quarter of your pension can generally be taken tax-free. It's the single most well-known fact about pensions and the source of a decision that a lot of people make badly, usually by making it too soon.

The rules

Up to 25% of each pension can be taken free of income tax, subject to an overall cap of £268,275 across all your pensions, known as the Lump Sum Allowance.

For most people the 25% limit binds long before the cap does. You'd need pensions totalling more than about £1,073,100 for the overall figure to matter.

You don't have to take it all at once. This is the part people don't realise, and it matters more than anything else on this page.

Some people have protected tax-free cash above 25%, usually from older schemes or from protections claimed under previous regimes. If you have any protection certificate, check before taking anything, because acting first and asking later can forfeit it. See The Lifetime Allowance, and the three limits that replaced it.

Some defined benefit schemes work differently. The 1995 Section of the NHS scheme, for example, pays an automatic lump sum rather than offering a choice. Others let you exchange pension for cash by commutation at a rate that's usually poor value.

All at once, or gradually

Taking the lot means the whole 25% comes out on day one. The remaining 75% goes into drawdown, and every future withdrawal from it is taxable.

Phasing means crystallising only part of your pension at a time. Take a quarter of the part you crystallise as tax-free cash, leave the rest untouched and still growing.

Phasing has three advantages and they're substantial:

The uncrystallised part keeps growing, and 25% of a larger figure later is more cash than 25% of a smaller figure now.

You can combine tax-free cash with taxable income to produce the income you actually need while minimising tax, which is the whole subject of Which pot do you spend first?.

It avoids the trap below.

The trap

The most common expensive mistake with tax-free cash is taking it because you can, and putting it in a savings account.

Money inside a pension grows free of income tax and capital gains tax. The same money in a savings account earns interest that's taxable above your Personal Savings Allowance, and until April 2027 it also sits inside your estate for inheritance tax when the pension didn't.

So a large lump sum taken at 57 and left in the bank until it's needed at 70 has been moved from a highly efficient environment to a less efficient one, thirteen years early, for no reason other than availability.

Take tax-free cash when you have something to do with it. Clearing a mortgage, funding the gap before the State Pension starts, a specific purchase, a genuine plan. Not because you've reached the age where you're allowed.

What the 2027 change does to this

From April 2027, unused pension funds are expected to fall within the estate for inheritance tax.

That weakens one of the arguments for leaving money in a pension, and for an estate above the nil rate bands it can change the calculation meaningfully. Drawing tax-free cash and spending or gifting it may become more attractive than leaving it untouched.

It doesn't reverse the general point. Money you don't need still grows better inside the pension than in a savings account, and the tax-free cash is still tax-free whenever you take it. But if your estate is likely to face inheritance tax, this is worth modelling properly rather than assuming the old logic holds. See What happens to what's left.

The MPAA point

Taking only tax-free cash does not trigger the Money Purchase Annual Allowance. Taking taxable income does.

That distinction matters enormously if you're still working or might return to work, because triggering it permanently drops your future pension contribution allowance from £60,000 to £10,000.

So someone who needs a lump sum at 58 while still employed can usually take tax-free cash without any effect on their ability to keep contributing. Taking taxable income alongside it closes that door for good. See Annual Allowance and tax relief.

Questions worth answering first

What is it for? If there's no answer, that's an argument for waiting.

Would clearing debt with it save more than the pension would earn? Often yes for a mortgage at current rates, and that's a legitimate use.

Do you have protected tax-free cash? Check before acting.

Are you still contributing to a pension? Then take cash only, not income.

What does it do to your estate? Particularly relevant from 2027.

Would phasing work better? For most people with flexible pensions and no immediate large need, it usually does.

The Retirement Readiness Calculator models the tax-free element alongside your other income, so you can see what taking it at different points does to the overall picture.

This article is for general education only and isn't personal advice. Tax-free cash decisions are largely irreversible and interact with protections, allowances and your estate.