Early withdrawals from pension tax-free lump sums could cost savers up to £63,000

When money is added to cash savings accounts, savers may also be subject to income tax

According to new research, individuals over 55 who take their 25% pension tax-free lump sum early instead of investing it could end up 63,000 worse off.

According to AJ Bell, a 55-year-old who chooses to withdraw their entire lump sum allowance from a 500,000 pension fund and deposit it into a cash savings account that pays 4% could be 63,169 worse off by the time they are 65.

According to the analysis, they might still lose out on 45,029 in returns even if they withdrew their entire lump sum and gradually transferred it into a cash ISA. Compared to letting the money grow in their pension fund, they could still lose out on 18,358 if they invest it in a stocks and shares ISA, where returns are anticipated to be higher.

The warning coincides with rumors that Chancellor Rachel Reeves may lower the amount of tax-free cash pensioners can receive upon retirement, leading many people over 55 to take early withdrawals from their pots.

Rumors of changes to pension regulations, according to Tom Selby, director of public policy at AJ Bell, run the risk of frightening people into making snap decisions.

"The decision to access your tax-free lump sum is not one that should be taken lightly under any circumstances, whether there are rumors swirling or not," he stated, citing the possibility of a medium-term hit worth tens of thousands of pounds.

Tax on savings.

According to AJ Bell's analysis, a 55-year-old who takes their pension tax-free lump sum early may not only lose out on pension pot growth, but any money moved to another account may also be subject to savings tax.

For instance, the Personal Savings Allowance (PSA) would apply if the funds were transferred to a cash savings account.

Before paying taxes, basic rate taxpayers can earn up to £1,000 in savings interest annually, while higher rate taxpayers can earn up to £500. There is no allowance for someone in the additional rate band.

Pensioners account for 44% of all taxpayers who are taxed on their savings interest, according to a recent FOI that AJ Bell obtained from HMRC.

Even if the money from the pension tax-free lump sum is eventually transferred into an ISA, the owner may still be liable to capital gains tax or dividend tax if it is invested in the stock market.

According to AJ Bell, this is because the current annual cap of £20,000 would require a lump sum to be added to ISAs over a number of years, leaving a portion of the money subject to tax in the interim.

"It is important to have a clear plan for your money when accessing your pension, whether by taking a lump sum or a regular income," stated Selby.

"Leaving money in your pension until you need it is frequently the best course of action, even though you might want to use it to pay off the remaining balance on a mortgage or other debts.

In a few years, you should be able to take out a larger tax-free cash lump sum because it can continue to grow tax-free. The "

AJ Bell is the source. assumes that the person is a higher rate taxpayer who works full-time until age 65 but stops making pension contributions, and that investments in the pension and stocks and shares ISA will grow by 6% after charges. Four percent is the assumed interest rate for cash accounts and cash ISAs. In both the Cash and Stocks and Shares ISA scenarios, a lump sum is drip-fed into the ISAs in annual increments of 20,000 (in accordance with the annual ISA allowance of 20,000) until the entire amount is invested in the ISA.

Risks associated with withdrawing the 25% tax-free pension early.

If someone is thinking about withdrawing their 25% tax-free lump sum early, they should consider several possible drawbacks.

First. A pension's withdrawal funds cannot increase.

If you take out 25% of your pension fund tax-free, you will still have 75% invested, with the possibility of further compounding and growth, but if you leave it all in, you might end up with even more.

Two. Currently, inheritance tax does not apply to funds in a pension.

Inheritance tax (IHT) will be applied to pensions starting in April 2027.

On the other hand, if you passed away prior to this date, your beneficiaries should be able to receive funds from a defined contribution pension plan without having to pay an IHT.

On the other hand, any funds that are not included in your pension fund may be included in your estate and subject to IHT.

#3. In the long run, you might have less money overall.

Early lump sum withdrawals may provide you with much-needed cash now, but they may cause you to struggle later on because you will be spreading your pension fund over a longer time period.

Pension calculators, such as those found on the moneyhelper website, can predict your likely pension amount based on your state pension, personal pensions, and workplace pensions.