MANY people look forward to the moment when they can at last get their hands on the money that they’ve saved over the years inside a pension.

Often the first port of call is the 25% of a pension pot that the rules usually allow you to take tax-free.

But you shouldn't rush into making a decision. There are a few things you need to know about before taking your cash lump sum.

What will you do with the money?

It can sometimes feel as though money inside a pension only becomes real once you’ve withdrawn it and brought it into the ‘real world’. That’s perhaps why most people choose to access their tax-free cash as soon as it becomes available - currently from age 55 although that limit, known as the ‘Normal Minimum Pension Age’ is due to rise to 57 in April 2028.

But it is important to understand the implications of that decision. Money that remains inside a pension enjoys some advantages in the tax system. If you withdraw tax-free cash and place it inside a savings account or other investments, any returns it earns could be subject to tax whereas it would have grown tax-free in your pension. You may be able to rehome your tax-free cash inside an ISA to avoid this, but what you can pay in is limited, currently to £20,000 a year. It's important to remember that tax treatment is based on individual circumstances and all pension and tax rules may change.

What’s more, the bank deposit will be included in your estate for inheritance tax purposes (more on that below), whereas it is exempt from inheritance tax while in a pension and having additional assets in a bank account may affect your ability to claim certain state benefits.

That means taking tax-free cash should only be done if you have a good reason. There are plenty of reasons why it may still be a good idea - if you want to pay off debt, or perhaps help grown-up children to buy a house, for example - but withdrawing it to simply sit on it may not work in your favour.

And remember, you don’t have to take the whole 25% that is available, you can simply take out what you think you’ll need and leave the rest.

What will be the impact on your income in the future?

The money in your pension is primarily there to provide income for your retirement. That may be by using it to purchase an annuity or by taking an income flexibly via drawdown or in lump sums - you can read more about retirement income options here.

By taking out 25% of your pot you will be reducing your pot’s ability to generate income in the future. Furthermore, by doing so from age 55 - when you may still have many years before you retire completely from work - you are removing the opportunity for that money to potentially grow in value via investment returns, although that is not guaranteed and your money can lose value.

Consider that 25% of £80,000 amounts to a tax-free lump sum of £20,000. But, if that money was left invested and the pension savings grew to £100,000 it would provide a tax-free lump sum of £25,000. That means that £5,000 more of your pension savings could be taken tax-free.

You can get an idea of the impact of withdrawing tax-free cash by using online calculators. Fidelity’s Pension Tax Calculator allows you to enter the value of your pot, when you plan to take it and the level of tax-free cash you plan to take, to show you the impact on your likely income in retirement.

Do you expect to pass money on to loved ones?

Passing on an inheritance to family and loved ones is an aim for many people. Those with significant wealth run the risk that the money they leave is subject to Inheritance Tax (IHT). Money held within a pension is generally outside of IHT and will fall outside your estate for IHT purposes.

That could be a reason to leave it where it is if you can meet your financial goals another way.

Is now the best time to withdraw from your invested pension pot?

  • If you don’t need the money right away and have some flexibility about when you take your tax-free cash, try to avoid taking it immediately after investments in your pension pot have suffered a heavy loss. Don’t sweat over small market movements, but if there has been a big market fall you risk locking in those losses before your pot has had a chance to recover.
  • If you have a very large pension pot, upward market movements could mean the tax-free amount could be subject to the lump sum allowance (LSA). This is the maximum amount of tax-free cash you can take from your pension savings in your lifetime. You can take 25% of your pot tax-free, as long as this amount is not higher than the LSA. The standard LSA is £268,275.

    Some people might have a higher allowance if they also had a higher protected lifetime allowance.

Could you benefit from some help?

Planning your retirement finances is not always straightforward and balancing the benefits of different courses of action can be difficult without the help of professionals.

Thankfully, there is plenty of help at hand. The Government provides a free guidance service called Pension Wise which allows to you to discuss your retirement income options, including the implications of taking tax-free cash.

Others may benefit from paid-for professional financial advice that is tailored to their situation. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser of your choice. They can provide you with a personal financial strategy to help you achieve your investment goals.

What will you do with the money that’s left in your pension?

Deciding to withdraw tax-free cash is not the only decision you need to make - you must also decide what to do with the money that’s left inside your pension.

The appropriate course of action will depend on your wider financial circumstances and your plans for the years ahead. Those who take financial advice should be given a clear plan of what to do but it is harder for those who proceed without it.

To help them, anyone in that position is offered one of four ‘Investment Pathways’ for money left within pensions. They are asked questions about their future plans. Do they wish to leave their money untouched for the next five years? Do they plan to take all of their pension money out within the next five years? Do they plan to set up a guaranteed income via an annuity? Do they plan to start using their money to provide a long-term flexible income? Or perhaps they want to do a mix of these options.

Once they have answered these questions, they can be guided to an investment solution that meets their needs.

Another question is what contributions you want to continue to make to your pension. If you take taxable withdrawals from a pension you are usually then limited in what you can pay in after that. This limit is known as the ‘Money-Purchase Annual Allowance’ and is currently set at £10,000 from 6 April 2023 - way below the normal £60,000 Annual Allowance (for most people from 6 April 2023 for) for pension contributions. Taking tax-free cash alone does not trigger MPAA - it only kicks in once taxed withdrawals are made. Prior to 6 April 2023 the Money Purchase Annual Allowance was £4,000 and the Annual Allowance was £40,000 for most people.