5 good reasons to take your tax-free cash - and 5 bad ones

It’s the question on everyone’s lips: is the Treasury going to restrict the amount that retirees can access tax-free from their pensions in the Autumn Budget? 

Last year too, speculation around this topic was rife - leading some people to panic and take their tax-free lump sums when they did not need them. This could prove very costly in the long run. Once outside a pension or an ISA, any growth or income from your investments suddenly becomes taxable. Over a 20 or 30-year retirement, that tax drag could make a significant impact on the size of your pot.

But there are good, valid reasons why someone might want to access their tax-free lump sum, regardless of what is announced in the Budget.

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The current rules allow you to take up to 25% of your pot as tax-free cash, but no more than £268,275 in total unless you hold protection.

Here we run through five good reasons to take your tax-free cash - and five bad ones.

Please remember that the below is not financial advice. Everybody’s circumstances are unique. For personalised advice, you should speak to a qualified financial adviser.

The good reasons

1. To pay off or reduce debt

Using a tax-free lump sum to clear a mortgage, credit card debt or loan could be one valid reason for taking the money. This is particularly sensible when interest rates are high. By clearing the debt, you should also reduce your monthly outgoings in retirement. 

2. To help family

If you had already planned to pass on some of your wealth to your children or grandchildren, then using a tax-free lump sum to do so could form part of a savvy financial plan.

If you know you want to (and can afford to) make a gift, the earlier you do so, the better. That way, you can see your loved ones make the most of the money and, once you pass on that wealth, the seven-year clock for inheritance tax (IHT) starts ticking. If you live another seven years after making the gift, it should be free of IHT so gifting early gives you the best chance possible of outliving that seven-year deadline. It is important to understand the detail in the rules, as we explain here: 5 IHT mistakes that could cost you thousands.

3. To retire early and bridge to state pension age

If you have saved enough money to retire early, then taking your tax-free cash could be a sensible way to bridge the gap to state pension age.

Using your tax-free cash before drawing on ISAs or the taxable part of your pension may help you to manage your overall tax position efficiently - although this will depend on your personal circumstances.

Make sure that retiring early and taking the lump sum doesn’t mean you risk the run of your money being depleted.

There are other options for how to bridge the gap between early retirement and starting to receive the state pension - including drawing on ISAs/savings or moving part of your pension into drawdown and withdrawing income gradually, some tax-free, some taxable.

The best option will depend on your individual situation, so it is well worth speaking to a financial adviser.

4. If you're over 75 and want to pass the money onto your spouse

Under current rules, when someone dies after age 75, the remaining pension can be passed on to beneficiaries IHT-free, but the person who inherits it will pay income tax on withdrawals at their own marginal rate.

If you are over 75 and still have unused tax-free cash allowance, you can withdraw that 25% portion yourself tax-free while you’re alive. If you then leave the money to your spouse, they should be able to inherit the money free of income tax and free of IHT - the latter thanks to the rules on spousal transfers. 

If you instead leave the whole pension untouched and die after 75, your spouse can inherit it and withdraw the same money, but their withdrawals are fully taxable at their marginal rate: there’s no longer any “tax-free cash” available to them.

It's important to note that IHT may be due on that money when the spouse dies and passes it onto their beneficiaries, so it makes most sense to do this if your spouse is likely to need to draw on that money. From 2027 pensions will be coming into the scope of IHT so the tax benefits of keeping money inside a pension will be reduced.
 

5. To maximise unused ISA allowances

If you haven’t used your ISA allowance, you might want to take some tax-free cash and put it in an ISA. That way the money will still be able to grow tax-free and you have the added benefit that withdrawals from an ISA are not taxable. Between a couple, you could potentially shelter up to £40,000 a year tax-free in ISAs.

Remember, you do not need to take the full 25% tax-free lump sum. If you only need to take £40,000, you can do so.

The bad reasons

1. Because the rules might change (but you have no plan)

Taking the tax-free cash just because you’re scared the rules might change could prove very damaging in the long-term - especially if you have no plan for how to use it.

If you have no ISA allowance available, any income or investment growth will be subject to tax, eating away at the value of your savings. Pensions are an incredibly tax-efficient vehicle and throwing those benefits away with no plan is unlikely to be a good idea.

2. Because markets are volatile

Some retirees may be concerned about market volatility and want to move some of their pension into a high-interest savings account to reduce risk.

However, holding too much cash over long periods can be incredibly damaging. Many savings accounts currently do not keep pace with inflation, eroding the value of your retirement savings.

What’s more, you do not necessarily need to take the tax-free lump sum to derisk your pension. You could leave the money in the pension and simply move it into lower risk investments, such as money market funds or bonds.

3. To make a big unplanned purchase

Splashing out on cars, boats, holidays can erode the value of your wealth quickly. If that purchase was always part of your financial plan, then great. If it wasn’t, you could find yourself running into problems.

Research shows that people generally underestimate their own life expectancy, meaning there is already a risk they have not correctly calculated how much money they will need post-work. Big unplanned expenses early in retirement will make matters worse.

4. To game the system

If you’re thinking of trying to game the system by taking your tax-free cash and then paying into a pension to benefit from another round of tax relief, think again.

The Government has rules blocking people from ‘recycling’ their pension money like this. If certain criteria are met and HM Revenue & Customs deems you did this intentionally, then you could face hefty tax charges of up to 70%.

5. To reinvest elsewhere

It may be tempting to chase higher returns outside a pension and use your tax-free lump sum to invest in, say, cryptocurrency or buy-to-let property which cannot be held within a retirement pot.

But, again, this means losing the tax-free growth you enjoy with a pension. What’s more, by exposing your retirement savings to these more niche investments you may be taking on much more risk than is wise.

Reminder: the Lump Sum Allowance

By way of reminder, the rules changed last year - on 6 April 2024, the Lump Sum Allowance (LSA) caps lifetime tax-free lump sums for most people at £268,275, which broadly equates to 25% of the old Lifetime Allowance. Some people have protections allowing more. So “up to 25%” is now practically “up to £268,275 (unless you have protection)”.

• Read: What can we expect in the Autumn Budget?
• Read: 5 IHT mistakes that could cost you thousands
• Read: How could the inheritance tax seven-year rule change?

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Eligibility to invest in an ISA or SIPP and tax treatment depends on personal circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.