Three pension pitfalls savers need to beware as they navigate tax changes and Budget uncertainty

• Taking your tax-free cash as a lump sum might not be the best thing to do – and will be irreversible 
• Beware pension recycling rules 
• Take care not to sabotage your ability to build your pension back up

Recent data shows that in 2024/25 the UK pension-holders delved into their savings at a higher rate than in previous years, with a 36 per cent increase in sums being withdrawn from pension pots from the previous year.[1] There has been a particular surge in people taking their tax-free cash as a lump sum, but all types of pension access saw significant increases in the 2024/25 financial year.

Philip Lewis, Head of Financial Planning Advice at leading wealth management firm Evelyn Partners, says: ‘Gradual annual increases in the overall amounts taken from pensions are to be expected as the population ages and more defined contribution pension holders reach retirement, but other factors are definitely at play with the recent growth in withdrawals.

‘The last few years have seen dramatic increases in the cost of living and borrowing, and many savers will be taking more money from their pensions to cope with this, or to help their children or grandchildren.

‘The announcement at the 2024 Budget that unspent pension assets will be subject to inheritance tax from April 2027 is also causing many savers to rethink the estate planning strategy of leaving pension savings as far as possible untouched to pass on at death. In fact, due to the double whammy of IHT and income tax for retirees aged 75 and above from April 2027, it could make sense for some individuals to “use pensions first” never mind last.

‘In addition, concerns before the last Budget that tax-free cash could be cut have resurfaced this year, and savers who are worried about this are taking their pension commencement lump sum, or thinking of doing so.

‘However, those who are accessing their pension fund without taking advice could be making some serious errors that would leave them counting the cost later in retirement. Moreover, HM Revenue and Customs has tightened up the guidance since the last Budget, so if you put a request in to take your tax-free cash lump sum, this time you won’t be able to reverse that decision if no changes are announced.’

The tax-free cash trap

Mr Lewis says: ‘Taking tax-free cash too early or without careful consideration might end up coming back to bite you tax-wise and could also undermine retirement plans.

‘Simply taking a large amount of money out of a tax-protected environment and moving it into a taxable one can backfire even if the pension withdrawal itself is tax-free. Any interest, income or capital gains that the sum earns from then on could be subject to tax unless it falls within allowances or is placed in another tax-protected wrapper like an ISA.

‘Taking the PCLS is best done as part of a plan, with a picture of how your future years of retirement will be funded, and it’s hard to beat cash-flow modelling from a professional financial planner for that. It also helps if there is a clear purpose for the sum, such as paying down the mortgage, gifting, or taking an income. But for others, a good financial plan might recommend leaving it untouched for several years more, or taking the 25 per cent tax-free element of the pension gradually in tranches.

‘In the wake of some chaos after the last Budget when many savers scrambled to cancel their PCLS withdrawals, HMRC advised that pension providers should not allow savers to reverse decisions to take tax-free cash. It now looks like the FCA will confirm that people can’t cancel their TFC withdrawal within a cooling off period, as some providers allowed after the last Budget, and this clarity might force people to think twice about the step. [2]

‘The probability of action on the PCLS at the Budget seems currently quite low as it would not generate significant revenue quickly and could meet opposition from higher earners in the public sector.

‘So in summary, we would definitely urge caution and highlight the value of advice before withdrawing large sums from pensions.’

‘Pension recycling’

Mr Lewis adds: ‘Some savers might optimistically think, even though they’ve taken their TFC when they don’t really need it, that they can just start paying it back into a pension. However, pension recycling rules are designed to prevent this, as it means tax relief is effectively being granted twice on the same income. With the UK’s generous system of pension tax relief, guardrails are in place to prevent it being “gamed”.

‘The good news is that just taking the PCLS does not reduce the amount a saver can pay into their pension each year with tax relief, as the “money purchase annual allowance” (MPAA) is not triggered. So most people who are not very high earners and subject to the tapered annual allowance can continue to pay in up to the AA of £60,000 (depending on their earnings) even after they have taken their PCLS.

‘This can be very useful to those who want to take their tax-free cash soon after they turn 55 but also remain in work and build their pension back up.

‘The bad news is that HMRC will be watching out for large or increased pension contributions by those who have just taken their TFC. If making pension contributions shortly after taking TFC, it is important for savers to speak to an adviser about what is and isn’t considered “recycling” under the pension rules.’

Triggering the MPAA

Mr Lewis says: ‘The FCA data shows only around 31 per cent of people take advice when accessing their pension for the first time.[1] How you access your pension is crucial and another reason why those contemplating taking their tax-free cash would be wise to work with an adviser – as much depends on what you do with the rest of the pot.

‘If you access your pension flexibly or take taxable amounts then you risk triggering the MPAA which will limit future contributions to £10,000 a year and could hamper your ability to rebuild your pension pot.

‘When taking the PCLS, as long as you leave the rest invested, or use it to buy a guaranteed income from a lifetime annuity, the MPAA doesn’t come into play. It is however triggered by flexibly accessing a money purchase pension, which typically involves taking an “uncrystallised funds pension lump sum”, starting to draw an income from a flexi-access drawdown plan, buying a flexible annuity, or encashing a pension in full.

‘As the FCA data suggests that at least 54 per cent of those who accessed a pension for the first time in 2024/25 did so in a way that would trigger the MPAA[1], this is obviously not a negligible issue, although it does only limit those who are able and inclined to subsequently pay more than £10,000 a year into their pension.’

NOTES 

[1] https://www.fca.org.uk/data/retirement-income-market-data-2024-25#full 

[2] Pension savers told they cannot reverse lump sum withdrawals ahead of Budget