How would you spend your 25% tax-free pension lump sum?

One in five over-55s have spent or plan to splash out their pension tax-free cash on home renovations like conservatories, new kitchens and loft conversions, new research reveals.

After property improvements, which topped the most wishlists, 16 per cent of over-55s choose to buy a new car, and 15 per cent to pay down mortgages or other debts.

Taking a tax-free lump sum of up to 25 per cent from your pension fund is a popular perk at retirement, although you can opt to leave some or all of it alone to boost your income in later life. 

What do YOU want (or need) to spend 25% tax-free pension cash on?

Some 14 per cent of the over-55s polled by Standard Life earmarked the money for everyday spending, 13 per cent for a short holiday and 7 per cent for a trip of three weeks or more.

Another 7 per cent opted for mitigating current cost of living pressures, 5 per cent for buying property, and 4 per cent for gifts to children and grandchildren or supporting them with living costs.  

Standard Life found 20 per cent of people still working either full or part time would use tax-free pension cash to pay their mortgage or other debts, compared with 12 per cent of those who were not working.

The pension giant surveyed 2000 adults, weighted to be nationally representative, in May. 

It asked the 280 who were over 55, the age at which you can typically start tapping your pension (due to rise to 57 in 2028), how they plan to use or what they already did with their 25 per cent tax-free cash.

If you have a large pension pot, there was an important change following the ditching of the lifetime allowance in April 2023 – the £1,073,100 total limit people could have in their pension pot without facing tax penalties.

The 25 per cent tax free lump sum is now capped at £268,275 – a quarter of the old lifetime allowance limit.

However, if you have fixed protection relating to a previous more generous lifetime allowance level your higher 25 per cent lump sum figure can apply, even if you start paying into your pension again.

Fixed protection is a complicated area and it is best to seek professional financial advice.

> How to defend your pension from the taxman: Eight tips from the experts

How do tax-free lump sums work?

Many people nearing retirement age may have a mix of defined contribution and defined benefit pensions.

Defined contribution pensions: These take sums from both employers and employees and invest them to provide a pot of money at retirement.

Over-55s can take 25 per cent of their pension pot tax-free upfront, or opt to withdraw it gradually in chunks.

By not withdrawing the whole lump sum out at once, if your pot grows in future you will have more tax-free cash available to take in the longer run.

Defined benefit salary-related pensions: Final salary or career average defined benefit pensions provide a guaranteed income after retirement for the rest of your life.

Your options for a 25 per cent lump sum vary according to the generosity of the terms and conditions of your scheme, so you will have to check the specific details.

Our columnist Steve Webb explained how defined benefit pension lump sums work and how to work out if they are good value.

You have the option of transferring a final salary pension into a drawdown plan which is invested, although financial experts say this is rarely a good idea and the Government has placed safeguards against people giving up valuable pension benefits without realising.

If your final salary pension is worth more than £30,000, it is compulsory to take paid-for financial advice before giving it up.

Dean Butler:  One of the great benefits of a pension is that you can take a quarter of your pot without paying tax on a single penny

What to consider before withdrawing or spending your tax-free lump sum

‘One of the great benefits of a pension is that you can take a quarter of your pot without paying tax on a single penny of it, all the way up to a maximum of £268,275,’ says Dean Butler, managing director for retail at Standard Life.

‘If you’ve kept up your contributions and grown your pot over a number of years, this could equate to a substantial amount of tax-free money by the time you come to take your savings.

‘It’s interesting to see how people choose to make the most of this hard-earned boost. At the moment it looks like many decide to invest in some long-awaited home improvements – perhaps partly motivated by being cooped up during lockdown years staring at everything wrong with their homes.’

He adds: ‘You don’t have to take all your tax-free cash at once if you don’t want to. It’s good to set some time aside before spending to work out how to get the most out of it.’

Butler offered the following tips for people with defined contribution pots, though some will also be useful to those with defined benefit pensions. 

1. Remember your whole retirement: It can be tempting to spend the cash immediately, but remember your pension savings need to last you throughout your retirement – which will hopefully be a long and happy one.

Taking too much at once, or too early, could mean that you possibly run out of money later.

2. Consider future investment growth: ‘Leaving your pension savings invested for longer gives the opportunity for additional growth, so it can make sense to put off accessing your savings for as long as possible to benefit even more in the future.

3. Think about being as tax efficient as possible: Taking your tax-free lump sum in chunks over time can be a tax-efficient way of withdrawing your pension savings and can help spreads the benefit over multiple years.

Some people also choose to use their tax-free lump sum as way of reducing their working hours and starting a phased retirement.

If you cut back on your hours, you could use some of your tax-free lump sum to top up your reduced salary.

4. Be aware of your tax allowances: It’s good to know that before you access any taxable income from your pension plan, the total amount you can pay in each tax year and still get tax benefits is £60,000, or your total salary, whichever is lower, and then you’d need to pay a tax charge for anything over this amount.

However, once you do start taking taxable income, for most people this will reduce to £10,000 a year.

This is a really important consideration when working out plans for taking your retirement savings, particularly if your plan is to keep working and paying in after you start to take your money.

> How the pension annual allowance works: The key rules explained

This post first appeared on Dailymail.co.uk