Pension frenzy: Three things to think about before taking an early withdrawal are the surges in lump sum withdrawals by 55-year-olds

Future changes to inheritance tax laws are predicted to increase younger retirees' demand for pension funds in the upcoming years, raising concerns among experts that they may run out of money

A post-pandemic high was reached last year in the number of people taking lump-sum withdrawals from their pensions as soon as they could. According to experts, the trend will pick up speed before future changes to the inheritance tax rule.

In 2023, 120,000 people took a lump sum payout from their pensions at age 55, compared to 120,000 last year, according to a Freedom of Information request made by Lubbock Fine Wealth Management to HMRC.

In 2024, the total value of those lump sum withdrawals by individuals between the ages of 55 and 56 reached a five-year high of £2.02 billion, up 10% from £2 billion.

According to Lubbock Fine, pressures from the rising cost of living are probably forcing many people to take their pensions early, which raises worries that they may run out of money later in life.

Because of longer life expectancies and rising health care costs, people are more likely to deplete their pensions too soon.

"The significant number of savers taking withdrawals from their pensions prior to actually retiring is extremely concerning," stated Andrew Tricker, director of Lubbock Fine Wealth Management. An excessive number of them are withdrawing too soon.

Because people are living longer, it is more expensive than ever to fund retirement because money taken out early will need to be replaced. When you're in your 80s, decisions you make at age 55 can have a big impact.

Do I have to take my pension out to avoid paying inheritance tax?

Recent modifications to inheritance tax (IHT) regulations that will take effect soon could hasten this trend of lump sum pension withdrawals.

Beginning in April 2027, the majority of unused death benefits and pensions will be counted toward an individual's estate value. Because of this, pensions are a less useful instrument for transferring wealth.

Because gifts given seven years prior to death are exempt from IHT, these changes may cause people to take money out of their pensions early and give it to friends or family. Their estate's value will decrease as a result, lowering their IHT liability.

However, Lubbock Fine cautioned that people should be mindful of the tax implications, especially with regard to the money purchase annual allowance (MPAA). When taxable income is deducted using a flexible payment option from a defined contribution pension, the MPAA is activated.

The MPAA applies and the annual allowance, or the amount you can contribute to a pension pot and still receive tax relief, is lowered to 10,000 (from 60,000 or 100% of earnings, whichever is lower) if taxable income is added to the available 25% tax-free lump sum allowance. Employer pension contributions are likewise subject to this reduced allowance.

Tricker stated: "At age 55, people need to be extremely cautious when taking withdrawals from their pension funds. Activating the MPAA can significantly lower your future pension contributions, which frequently surprises people later in life.

"Anyone who is thinking about taking their pension for the first time or increasing withdrawals to deal with growing living expenses should pause and consider their options before acting hastily," stated Tom Selby, AJ Bell's director of public policy.

"Withdrawing too much money too soon or taking money out of your retirement fund too soon could have disastrous long-term effects.

Before you take early access to your pension pot, think about these three factors.

Here are three reasons why Selby advised "stopping and thinking" before taking immediate advantage of your pension pot at age 55.

The risk of running out of money in retirement is increased by early access.

If you take out too much money from your fund too soon, you run the risk of running out of money too soon and possibly having to rely on the state pension.

Consider a healthy 55-year-old who has a pension fund of £100,000. According to AJ Bell's calculations, their fund might run out by the time they are 80 years old if they take out £5,000 annually, increasing by 2% in line with inflation, and enjoy 4% annual investment growth after charges.

Given that a healthy 55-year-old's life expectancy is in the mid-80s and that they have a good chance of living well into their 90s, such a strategy would obviously put you at serious risk of running out of money too soon.

"To put it simply, if you raid your pension pot too soon, you'll either have to limit your withdrawals, which could negatively impact your quality of life later in retirement; find other sources of income; or confront the possibility that your pot will run out sooner than anticipated and you'll be left depending only on the state pension," Selby said.

Additionally, you might lose out on investment growth if you have early access.

Missing out on investment growth at the same time will exacerbate the sustainability issues brought on by taking an early pension income.

Savers are completely free to choose how to invest their retirement funds, but once you start receiving income from your pot, it usually makes sense to take a little less risk.

You may have between 12 and 24 months' worth of cash on hand, since you will at least need to sell some of your investments in order to take a withdrawal. In the long run, this lower risk portfolio will unavoidably have lower return expectations.

Additionally, if someone withdraws funds early, any growth from their investment will be applied to a smaller pot of money.

Consider a person who has a £100,000 pension fund, for instance. AJ Bell's calculations show that if they take out £10,000 on their 55th birthday and receive 4% investment growth after fees, their fund could be worth £133,000 by the time they are 65.

By the age of 65, their fund might be worth 148,000 15,000 more if they kept the 10,000 and experienced the same rate of investment growth.

You might result in a significant reduction in your yearly allowance.

According to Selby, "anyone thinking about taking taxable income out of their retirement pot for the first time needs to be aware of the severe impact it will have on their ability to save tax efficiently in a future pension."

Taking even one taxable income from your pension flexibly will result in the money purchase annual allowance, which could drastically lower the amount you can save in a pension tax efficiently to 10,000, which is far less than the 60,000 annual allowance.

Additionally, the MPAA will prevent you from carrying forward unused pension allowances from up to three prior tax years.

"Take your tax-free cash (or a portion of your tax-free cash) if you are having financial difficulties and your pension is the only asset available to support you. This won't trigger the MPAA," Selby advised.

As an alternative, you can access unlimited occupational pensions and up to three personal pensions worth £10,000 or less without triggering the MPAA, as long as you use up the entire pot at once.