Cashing in your pension: Think twice before taking your lump sum at 55

When it comes to retirement mistakes are easy to make. Perhaps the most common mistakes are made when you’re saving for retirement. Many people don’t start early enough or underestimate the amount that they do need to save in order to attain a comfortable standard of living. This problem and the various personal and policy solutions are frequently discussed in the media. However, perhaps one of the most common, yet inconspicuous, mistakes far too many people seem to make is when they start drawing from it. Taking the 25% tax-free lump sum could be an incredibly poor decision that too many people make. 

It may be tempting to take out a lump sum as soon as you can, but consider the cons first

From age 55 most of us suddenly have the ability to, for the first time, draw from our pension without facing a significant disincentive to do so, and what's more, we can draw 25% of our pot without facing any tax charge whatsoever. A lucky few take early retirement at this stage, but most of us carry on working until at least our mid-60s. Despite this, many people just think “Great, I can take 25% tax-free now from 55.” But you don’t have to take the 25% out at that point or in one go. Take whatever you need out, by all means, but there are many cleverer ways than just depleting your pot at the first opportunity, and a wide variety of reasons why you should do the opposite.  

First of all, by taking your 25% straight away you are reducing the overall amount of money available to provide you with a regular income in retirement. Your overall pot is smaller and therefore your monthly income could be less. For example, if you took 25% from a pot of £400,000 that you plan to last you 25 years then your retirement income would go from £16,000 per year to just £12,000. Therefore, you need to make sure you have mapped your retirement out fully and consider whether you need the lump sum to meet your immediate financial needs, or if you would be better off leaving the money invested in your pension to provide a higher retirement income in the long run. 

The longer you leave your lump sum, the more your pension will grow

By making your pot smaller by withdrawing the lump sum you could also miss out on investment growth. By leaving your money invested in your pension, you have the potential to continue benefiting from investment growth. If you took 25% of a pot of £400,000 from age 55 but did not retire fully until 65 then the remaining £300,000 would be worth £545,819 after ten years were it to grow at the industry average of 6% (not adjusted for inflation). However, were you to have not taken the lump sum then your pot would be worth £727,758 - yielding over £7200 per year more if you were to draw from the pot for 25 years.

Whatsmore you would be able to take a much bigger lump sum at that point if you wanted to, as you would still have tax-free access to 25% of the bigger pot. You’d also be able to leave more to your family if you died before drawing from your pot as your pension resides outside of your estate and doesn’t get charged inheritance tax.

Rather than taking out one big lump sum, consider taking out smaller chunks

Now, there may be some benefits to not taking your lump sum but this isn’t to say you absolutely should not take it, or at least take some of it. You may need that money for a purpose, however, many people take more than they need. Let’s say you take £100,000 and spend £10,000-£20,000 on something nice. What are you going to do with the rest of the money, put it in a cash bank account with a potentially lower growth rate than your pension pot? Once again the principles of investment growth apply as you potentially miss out.

You can also take multiple chunks of your tax-free sum. You don’t need to take it all at once. So let’s say you took twenty-five 1% chunks of your tax-free allowance, if your pot were to grow then the 25th chunk could be worth significantly more than the first. 

Overall, it's important to consider the potential impact on your retirement income, tax bill, and investment growth before deciding whether to take your 25% tax-free lump sum, when to take it and how much to take, if anything. It's always a good idea to seek professional financial advice to help you make an informed decision. 

If you need expert advice or help and support with your pension and retirement planning from a trustworthy source, contact Unbiased today.

Read more: Why you should pay now to fill gaps in your State Pension

Read more: How to trace a lost pension

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