Are you thinking about accessing your pension early?

If asked what our pensions are for, most of us would, understandably, answer with “retirement”, quite possibly followed by “obviously” or “of course”.

But while we all know that it’s our pensions we’ll be calling on to pay the bills when we do eventually finish work for good, a significant number of us are dipping into our pots well before that.

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According to the latest Financial Lives survey from the Financial Conduct Authority (FCA), as many as 35% of non-retired over-55s had already taken either a lump sum or income from their pension.

Peter Cranwell, an independent financial adviser at AAF Financial is concerned about the trend.

“There is no doubt that since the introduction of Pension Freedom in 2015, many people’s attitudes towards pensions shifted dramatically: gone were the days of taking your tax-free cash and then buying an annuity. Now, there is (assuming you have reached age 55) the possibility of additional lump sums; an income that can be increased, decreased or even halted. So now the pension has more of the flexibility of a bank account in some peoples’ eyes – albeit with age restrictions regarding access.”

He adds: “The primary function – to provide a stable income throughout retirement years that will protect a certain standard of living – has been undermined.”

There are numerous reasons why over-55s raid their pension but Cranwell says that, in his experience, people are most likely to take a lump sum out of their pension to pay off their mortgage or to gift money to their family. “Boosting earned income while continuing to work part-time is another,” he adds.

The price of flexibility

While this flexibility might make life a little easier in the moment, Cranwell warns that it won’t be doing your long-term finances any favours. By taking money out of your pension before you retire, you’re reducing the amount of time it has to grow and therefore reducing the amount of income it will be able to generate in the future. “Given that life expectancy continues to increase, this may mean an uncomfortable retirement in later years, and the potential that funds could run out.”

He adds: “If funds are exhausted you may have to rely solely on the state pension – and if you have taken your benefits particularly early, that may mean a pension income gap of many years, with the state pension age to rise to 68 [between 2044 and 2046]. This, in turn, could mean that you have to work longer.”

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However, it’s not just the risk of running out of money that over-55s need to worry about. If you take a lump sum out of your pension without then going into drawdown or buying an annuity, (referred to as an ‘uncrystallised fund pension lump sum’, or UFPLS) the tax bill can come as an unwelcome surprise.

Ian Futcher, a financial planner at Quilter, explains: “While the first 25% of your pension withdrawal is usually tax-free, the remaining 75% is treated as income and taxed at your marginal rate. This means a large withdrawal in one go could push you into a higher tax bracket, resulting in a much bigger tax bill than expected. In some cases, people have taken out lump sums and lost thousands unnecessarily in tax.”

Complicating matters further is the fact that you will also likely pay emergency tax on your withdrawal. This is because HMRC will assume that it’s the first of a series of payments, rather than a one-off lump sum. Although you will be able to claim any surplus back, you’ll need to factor it into the planning process if you need a specific sum.

Cranwell also says it’s important to note that just because you’re drawing on a pension, you won’t be entitled to any special treatment from HMRC. “I have often encountered a misconception that pensioners receive a higher personal allowance than other tax groups – they do not.”

Beware the money purchase annual allowance

Before you make an UFPLS withdrawal, it’s also important to be aware that the amount you’ll be able to pay into your pension going forward will also likely be reduced. This could be particularly restrictive if you’re a higher earner, or you are likely to have any lump sums (for example a work bonus or inheritance that you want to pay into your pension).

“Once you access your pension beyond the tax-free amount, you’ll trigger the Money Purchase Annual Allowance (MPAA), which drastically reduces how much you can continue to pay into your pension each year with tax relief — from £60,000 down to just £10,000,” says Futcher. “That’s a major blow for anyone planning to rebuild their pension in the future.”

The MPAA is triggered when you make a taxable and flexible withdrawal from your pension. The one exception is if you have any pensions worth less than £10,000 – you can cash in up to three personal pensions without triggering the MPAA under small pot rules.

Think about the alternatives

Before you take any money out of your pension, it’s essential to think about the effect it will have on your future financial security, the amount of tax you’ll need to pay, as well as any restrictions it may impose on your ability to build your pot back up.

If you need access to cash, there may be other ways to release money without undermining your retirement plans,” suggests Futcher. “Using ISAs, tapping into cash savings, or adjusting spending temporarily can be more tax-efficient alternatives.

“Another option worth considering is downsizing. For homeowners, selling a larger property and moving to a smaller one can unlock significant capital without incurring the same tax penalties as a pension withdrawal. It also has the added benefit of reducing running costs, which can help stretch your retirement income further.”

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Cranwell also has a pragmatic approach to borrowing. However much you want to be mortgage-free, your pension may not be the best way to clear it. “In my experience, clients will feel that ‘why borrow money when I already have it?’ This does not address the longer-term issue of funding retirement,” he says.

If you can’t avoid it: plan

If taking money out of your pension is your only option, it’s worth spending some time working out how to do it as tax-effectively as possible. That might mean taking only your tax-free lump sum, spreading withdrawals over several tax years, or keeping withdrawals (when added to other income) below the higher-rate tax threshold. You should also be aware that the earliest you can access your pensions is rising to age 57 in 2028.

If you’ve got any small pots – worth less than £10,000 – you might want to use these first. You’ll still pay tax on the withdrawal, but you won’t trigger the MPAA and reduce the amount you can save going forward.