What is the tax–free lump sum?

The tax-free lump sum is a feature of UK private pensions that allows you to withdraw up to 25% of your total pension pot without paying any Income Tax. This option is sometimes referred to as Uncrystallised Fund Pension Lump Sums (UFPLS). 

Unlike the other 75% of your pension, which is taxed as earnings when you withdraw it, this 25% portion can be withdrawn to your bank account in full. You do not need to take it all at once; you can take it in stages, or you can leave it invested if you don't need the cash immediately.

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How much of my pension can I take tax-free?

You can normally take 25% of your private pension savings tax-free, but there is a strict lifetime allowance on the total amount of tax-free cash you can draw.

This is called the Lump Sum Allowance (LSA).

• The current LSA cap is £268,275
• This represents 25% of a pension pot of £1,073,100. Anything beyond this amount is treated as taxable income. 

Some older pensions with ‘protected’ rights allow for a higher tax-free amount than 25%. Check your policy documents to see if this applies to you.

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Can I take my pension as a lump sum? 

You could technically take your entire pension at once, as a lump sum. However, if you cash in the whole pot, usually:

• 25% is tax-free
• The remaining 75% is taxed as income

It’s worth noting if you do decide to do this, the 75% taxable portion is added to your income that year. If you withdraw a large pot, this could easily push you into the Higher (40%) or Additional (45%) rate tax bracket; meaning you’d be taxed a huge chunk of your pension.

Note: There are several exceptions to the standard 25% tax‑free rule. These include serious ill‑health (where the whole pot may be tax‑free), small pots under £10,000, older pensions with protected tax‑free cash, defined benefit schemes with different calculation rules, and certain death‑benefit situations.

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Do I have to declare my pension lump sum? 

No, you do not need to declare the tax-free portion of your pension as it is not taxable income. However, if you take any cash beyond your tax-free Lump Sum Allowance, your provider will deduct tax before paying you. 

Providers typically have to apply an ‘emergency tax code’ to your first withdrawal, which may result in them over-taxing you initially. You would then have to reclaim this overpaid tax from HMRC.

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Lump sum: pay off your mortgage or invest? 

A common question for pension savers is whether to use their tax-free lump sum to pay off some, or all of their mortgage or to leave the money invested. Both options have advantages but the right choice depends on their personal circumstances.

Paying of your mortgage:

• By paying off debt, you effectively earn a ‘guaranteed return’ equal to your mortgage interest rate. If your mortgage rate is 5%, paying it off saves you that 5% interest cost. 
• Being mortgage-free would likely also reduce your monthly outgoings, meaning you need less income from your pension to cover your expenses.. 

Staying invested:

• If your investments grow faster than the interest you’re paying on your mortgage, for example, it’s returning 7-8% to your 4% mortgage interest, you could come out ahead.
• Property is an ‘illiquid’ investment — once your money is locked into property, it’s more difficult to access quickly. Keeping the funds in a savings or investment account usually leaves them more readily accessible.

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Pension drawdown

When thinking about what to do with the remaining taxable 75% of your pension pot, you have a couple of options. The first option covered in the next guide is the most popular; flexible drawdown. 

Flexible drawdown allows you to pay yourself an income of your choosing from your invested pension pot. It gives you the freedom to take as much or as little as you like, but it also means you’re responsible for managing your withdrawals and ensuring your money lasts throughout retirement.

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