Why cashing out your pension in full could be a costly mistake

In 2015, the pension freedoms came in, giving savers more choice over their pensions. But cashing out your pension in full can create significant tax and retirement planning issues. 

People no longer had to buy an annuity, and could instead leave their pension invested and draw from it, effectively turning the pension into a bank account. The pensions minister at the time even joked that people could go and blow it on a Lamborghini.

The reality is more complicated. If you cash out your pension, you receive the first 25% as tax-free cash. HMRC treats everything else you draw as income and taxes it accordingly.

A pension is not just a savings account. It is a tax efficient pot built up over decades. Cashing out your pension can undo years of planning in a single afternoon.

Cashing out your pension: the tax-free cash trap

Most people know the first 25% of a pension comes out tax-free. Fewer people realise everything above that is taxed as income in the year you take it.

Take a pension pot worth £64,000. The first £16,000 is tax-free, but should you take the remaining £48,000, that would be added to your income for that year.

It's very unlikely a financial advisor would recommend cashing out the entire £64,000 in one tax year. Spreading the withdrawal across multiple years usually keeps more income within lower tax bands. This can help you avoid an unnecessary higher rate tax charge.

If that pushes you into a higher tax band, a large chunk goes straight to HMRC. A single large withdrawal can push someone from basic rate into higher rate tax for that year alone.

This means the tax paid on the withdrawal can be far higher than expected. A pot that looked like £64,000 on paper can shrink considerably once the tax bill lands.

Cashing out your pension and running out of money later

There is also the question of running out of money later. Once a pension is cashed out and spent, there is no fallback income in retirement.

State pension alone is rarely enough to live on comfortably. Most people need a private pension, savings, or other income to maintain their standard of living once they stop working.

Better ways to reach the same goal

Some people cash out because they worry about pension rules changing, or because they want to clear debt quickly. Both are understandable concerns, but rarely require cashing out the whole pot.

Usually there are less costly ways to reach the same goal, such as drawdown, part withdrawals, or debt consolidation advice. A regulated advisor can usually find a route that avoids an unnecessary tax bill.

Means tested benefits

There are also means tested benefits to consider. A large lump sum in a bank account can affect entitlement to certain benefits in a way that untouched pension savings would not.

This is often overlooked until it is too late. By the time a benefit review happens, the lump sum has already been counted as savings.

Divorce settlements, inheritance planning, and future care costs can all be affected by a decision to cash out too. The rules treat pension savings differently from cash savings in several of these situations.

Watch out for the money purchase annual allowance

Another point worth considering is the money purchase annual allowance. Taking taxable income from a pension can trigger a lower annual allowance for future contributions.

This can catch out people who cash out early in retirement and then return to work later. Once you trigger it, the lower allowance stays in place. This limits how much you can pay into your pension tax efficiently in future.

Why timing matters

Timing also matters when deciding how to take money from a pension. Withdrawing in one tax year rather than spreading across two or three can be the difference between paying basic rate and higher rate tax on a large portion of the pot.

Spreading withdrawals across several tax years, where possible, keeps more of each year's income within the lower tax bands. This alone can save a meaningful amount of tax over time, without reducing the total amount eventually received.

You should also check whether your pension has any exit fees or guarantees before moving or cashing it in. Losing a valuable guarantee by accident is a common and costly mistake.