Finance experts warn millions of pensioners may be making a mistake when choosing how to access their pension pots. It all comes down to how people decide to draw from their private pensions once retired.
Experts say many are losing out by opting to withdraw the entire pot at once rather than smaller amounts over time. A recent Pensions Commission report highlighted that 48 per cent of all direct contribution pensions first accessed in 2024/25 were cashed as a complete lump sum, as retirees aimed to take full control of their finances. However, this may leave them out of pocket in later years due to tax laws, commentators warned.
Expert analysis of the two approaches
Antonia Medlicott, managing director of Investing Insiders, explained: "Whether or not cashing out your pension is the right move varies dramatically depending on personal circumstances. For smaller pots, where you have other sources of income for retirement, cashing them out can often be the simplest and quickest approach. With pots that have much higher values, that is when things start to get more complicated. In these situations, cashing them out is not often the best decision for your money. Instead, you should be thinking about how you can withdraw the money in the most tax-efficient way possible, whilst ensuring that you are set up for the rest of your retirement."
Antonia compared two scenarios using a £100,000 pension pot and the full state pension of £12,548 a year, topped up with roughly £7,358 a year from personal savings, providing an annual income of around £20,000.
Scenario one: Cashing out the entire pot
"In the first scenario, you take the full £100,000 from your pension in a single tax year. You can take the first 25 per cent tax-free, leaving you with £75,000 in taxable income. However, with the state pension using up nearly all of your £12,570 personal allowance, the entire £75,000 withdrawal is hit by tax. You pay 20 per cent on the first £37,700 of it and 40 per cent on the remaining £37,278, leaving you with a total upfront tax bill of £22,451 paid on the first day of your retirement. The remaining £77,549 can be invested in £20,000 increments into an ISA each year, which, with a 4 per cent growth rate, will last for 14 years if you withdraw the yearly £7,358 top-up."
Scenario two: Phased drawdown
"For the second scenario, you leave your £100,000 in your pension and use phased drawdown. Here, each withdrawal is 25 per cent tax-free and 75 per cent taxable, which, with a withdrawal of £7,358, means £5,519 of taxable income. After the state pension, almost all of that £5,519 is taxed at 20 per cent, equalling a total annual tax bill of £1,099. Done this way, the pension will last a full 20 years, with the total tax over this period being £21,987."
When comparing total tax paid, option A pays slightly more tax and runs out six years earlier, making it a much harder sell. On top of that, the £22,451 paid in tax on day one would have turned into £49,193 if it had stayed invested in a 4 per cent growth pension, showcasing the real cost of cashing out. It is not just the initial hit, but losing out on what that money could have become.
