Planning to draw from your pension ahead of Inheritance Tax changes? Read this first
More people than ever are choosing to take tax-free cash from their pensions, and many are doing so earlier than planned.
Figures reported by Saga for the 2024/25 tax year show that £18.08 billion was withdrawn from pensions as tax-free cash, a 61% increase on the £11.25 billion taken the year before. Over the same period, the number of people accessing their tax-free lump sum rose by 29.1%.
The tax-free lump sum allows you to take part of your pension without paying Income Tax. You can usually withdraw 25% of your pot up to a maximum of £268,275 for 2025/26, known as the Lump Sum Allowance (LSA).
But timing is key. If you take the tax-free portion of your pension too early, or all at once without planning, you may reduce your future retirement income and flexibility later in life.
So, read on to find out what’s behind the rise in withdrawals and why you should be cautious before following suit.
Two key reasons explain the surge in tax-free pension withdrawals
The data from Saga shows just how dramatic the rise in tax-free pension withdrawals has been, and two main concerns appear to be driving it:
Fear of a reduced LSA – Many people were worried the government would cut the LSA in the Autumn Budget, which would have meant those with larger pensions paying tax on more of their savings.
Upcoming changes to Inheritance Tax (IHT) – Reforms announced in the 2024 Budget mean pensions are set to fall within the scope of IHT from 2027, which has prompted people to withdraw money to use it more efficiently. You can read more about this in our previous article on the topic.
In reality, the feared cut to the LSA never happened. But by the time the Budget was announced, many had already taken money out of their pensions, and, once withdrawn, it usually can’t be put back. This highlights the risk of acting on speculation, as rushed decisions based on rumours can be detrimental to your long-term finances.
The second concern regarding keeping pensions tax-efficient under the new IHT rules has led more people to withdraw money early and pass it on during their lifetime. While this can work in some cases, it carries significant risks, and it’s important to have a plan if you intend to do so.
Other, more balanced strategies may be more suitable, and we’ll explore them below.
Whatever approach you’re considering to keep your pension efficient, it’s important to speak to a financial planner first.
Accessing your tax-free lump sum without proper planning comes with significant risks
Most people with a pension will eventually withdraw their tax-free portion, either as a lump sum or through drawdown, but it’s important to do so carefully.
The main risks of withdrawing your tax-free portion too quickly are that your retirement savings will lose the benefit of tax-efficient growth, and the cash you withdraw has a higher chance of falling behind inflation. This means you can be left with considerably less retirement income than if you plan your withdrawals over time.
Even if you reinvest your pension withdrawals elsewhere, you’ll likely pay tax on any returns, which can significantly reduce your long-term income.
Additionally, withdrawals can trigger the Money Purchase Annual Allowance (MPAA). This reduces the amount you can contribute tax-efficiently to a pension from £60,000 a year to just £10,000. If you’re still working and plan to top up your pension after drawing from it early, this could limit your future contributions.
So, careful planning is key. A financial planner can help you structure your withdrawals or drawdown in a way that maximises efficiency, keeps your savings growing, and aligns with your long-term retirement goals.
You can read more about how to create a retirement income plan in our previous article on the topic.
Other strategies can help keep your pension efficient
If you’re worried about IHT reducing what your loved ones receive from your pension, there are alternatives to simply taking a lump sum, including:
Maximising your tax-free allowances – You and your partner could pass on up to £1 million free of IHT, so it’s important to make full use of your available nil-rate bands.
Using life insurance held in trust – Using part of your pension to pay for a life insurance policy held in trust can be an efficient way to transfer wealth to beneficiaries. You can read about how this works in our previous article on the topic.
Investing in Business Relief (BR) schemes – Assets that qualify for BR can receive 100% IHT relief up to £2.5 million per estate, and couples can combine their allowances. So, using your pension to invest in a BR scheme could be a good way to keep it efficient.
Putting assets in trust – Assets held in trust are not considered part of your estate for IHT purposes, so using your pension to invest in trusts could help to keep it efficient. This could be investments, cash, property, or any other asset classes.
Incorporating gifting into a drawdown strategy – A drawdown plan can allow you to gift portions of your pension while keeping enough invested to support your retirement.
A financial planner can help you develop a strategy that balances your retirement income needs while also ensuring your wealth is preserved for the next generation.
To speak to a financial planner, get in touch.
Email info@mlpwealth.co.uk or call us on 020 8296 1799.
Please note
This article is for general information only and does not constitute advice. The information is aimed at individuals only.
All information is correct at the time of writing and is subject to change in the future.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.