The best (and worst) ways to take your tax-free cash

The Stanford marshmallow experiment was conducted in the 1960s. It involved 32 children aged between three and five, who were each presented with a choice: have one marshmallow now or have two later. They only secured a second marshmallow if they resisted eating the first one while the researcher was out of the room.

Many of us have lost our sweet tooth by the time we retire. However, pensioners’ will-power is tested in other ways. At age 55 - rising to 57 in 2028 - most people can take a quarter of their pension completely tax-free. An immediate sugar hit. Alternatively, they can wait and enjoy potentially more money further down the line.

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What do you do?

Well, there’s a snag. In the Stanford experiment, children who waited always received a second marshmallow. Their patience was rewarded every time. For pensioners, however, this isn’t the case. You could end up richer if you delay - but it’s not guaranteed.

As such, figuring out how and when to take your tax-free lump sum can be tricky. Nobody wants to get it wrong, and once you’ve tucked in you can’t easily reverse your decision. Sprinkle in some rumours thar the rules are about to change, and panic can easily ensue.

The process doesn’t need to be stressful or rushed, however. It is simply a case of knowing what options are available and devising a plan that works for you. 

How to access your tax-free cash

There are lots of myths around tax-free cash. The first is that you have to take all the money in one go. This is not true if you have a defined contribution (DC) pension. You can stagger your withdrawals in a whole variety of ways. (Going forwards, I’ll talk exclusively about DC schemes. Defined benefit schemes have different rules, which you can read about here.)

Another common assumption is that you ‘lock in’ the value of your tax-free cash when you first access your pension. Again, this is incorrect. If you leave some or all of your tax-free cash invested it can continue to grow alongside the rest of your pot.

There are four main ways to access tax-free cash from your pension.

1. Take all your tax-free cash in one go. This is the most familiar option. Take out your entire tax-free lump sum and leave the rest of your pension invested. You won’t be able to take any more tax-free cash in the future, but the rest of the pot can be accessed whenever you want, and withdrawals will be taxed at your marginal rate.
2. Take some now and some later. You are allowed to withdraw a portion of your tax-free cash now and leave the rest for later. With this approach - known as partial drawdown - you will be leaving more of your money invested, so it has the chance to grow. This could mean more tax-free cash further down the line.
3. Take all your tax-free cash - and some extra. You can withdraw as much as you want from your pension, but only the first 25% of the total value will be tax-free. The rest will be taxed like any other earnings.
4. Take out cash with some of it tax-free. This is a slightly more complicated way of accessing your pension. You take one or a series of lump sums, and 25 per cent of each withdrawal will be tax-free. The remainder will be taxed as earnings. This is called an uncrystallised funds pension lump sum, or UFPLS. (The pension industry is packed with horrible acronyms. For an explanation of key terms, please go to our jargon buster below.)

There are a couple of caveats. First, the amount of cash you can take tax-free is not limitless. It is currently capped at £268,275. This is known as the lump sum allowance, or LSA¹.

Second, not all pension plans are created equal. Some won’t offer all four withdrawal options, so make sure you find out what is possible before you get stuck into planning. Meanwhile, some older schemes offer ‘protected’ tax-free cash, which can push your overall tax-free limit higher². These schemes can be complicated - and lucrative - so it is worth seeking specialist advice if you have one.

Whatever your situation, though, you need to ask yourself a few basic questions. Starting with…

Do you have a plan for the money?

The desire to take all your tax-free cash upfront can be strong - and it probably got even stronger last year, when there were rumours the government was going to tighten the rules. A record 211,000 people withdrew £18.3bn in tax-free cash in 2025, a 62 per cent jump on 2024³.

Taking tax-free cash without intending to spend it can be damaging, however. This is because pensions are extremely tax efficient, allowing you to grow your wealth free from capital gains tax (CGT). Once money has left the cocoon of a pension, however, it is exposed to the elements.

If you reinvest the money in a general investment account, for example, you could face a nasty CGT bill when your assets grow. Similarly, if you put it in a savings account you could end up paying tax on the interest. An ISA would offer protection, but the annual ISA allowance is set at £20,000. This means you might have to drip feed the money in over many years.

Some pensioners take the cash and simply stick it in a bank account, which limits the tax hit. However, it means they are missing out on potentially valuable growth.

On the flip side, you might have big plans for the money. Maybe you are poised to pay off your mortgage or have budgeted for a well-earned holiday. You might want to gift some money to your children or grandchildren. In these scenarios, taking the cash upfront could make significantly more sense.

This is particularly relevant given unused pensions will be subject to inheritance tax (IHT) from next year. In the past, it was often wise to keep as much money as possible within a pension wrapper to protect it from IHT and draw from other accounts instead. The upcoming rule change means the balance has shifted, however⁴.

Do you intend to keep working?

Another thing to consider is whether you are still working - specifically, whether you are still paying into a pension. Depending on how you take your tax-free cash, you might stumble into something called the money purchase annual allowance, or MPAA. This limits how much you can save into your pension each year and still benefit from tax relief.

The MPAA dictates that your annual pension contributions must be less than £10,000, compared with the full annual allowance of £60,000. This includes money paid in by you and your employer. If you accidentally trigger the MPAA while you are still working, you could lose out on valuable tax relief - and once applied, it’s permanent⁵.

Working out what triggers the MPAA is a bit fiddly. It kicks in after you flexibly access the taxable part of your pension for the first time. For example, if you withdraw all your tax-free cash and something extra, or if you take a lump of your pension consisting of both taxable and tax-free cash.

In other words, it is triggered by options three and four in the list above, but not by options one and two. There are some additional rules to be aware of around annuities and small pots.

What other sources of income do you have?

So far, we’ve talked about spending plans, investment growth and future pension contributions. Another key factor is income. How you take your tax-free cash can have a big impact on how much income tax you pay in the future.

To recap: you can typically take a quarter of your pension tax-free, and the rest is taxed at your marginal rate - as if you were being paid a salary from a job, but without the national insurance. At a basic level, most people avoid taking a huge chunk of their pension upfront as it would risk pushing them into a higher tax bracket. Instead, they stagger their withdrawals over many years.

Tax-free cash plays a specific role here. Let’s say you are 61. You have stopped working but you will not receive your State Pension for another five years. You plan to use only your private pension to bridge the gap, taking income of roughly £17,000 a year.

You might be tempted to take your tax-free cash before touching your taxable income. You could withdraw it in five instalments, for example, spread over five years. No tax to pay - lovely.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). Tax treatment depends on individual circumstances and all tax rules may change in the future. 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.