Is a pension lump sum taxed?

Most lump sums from public sector pensions are tax-free. You can usually take up to 25% of the value of your pension benefits as a tax-free lump sum, up to a maximum of £268,275 across all your pensions. That limit is called the lump sum allowance. Tax only applies to any amount above the allowance, and your pension provider takes it off before paying you. The pension you still receive each year is taxable income as normal.

The two limits

Since 6 April 2024 two limits apply. The lump sum allowance is £268,275 and covers pension commencement lump sums, the 25% tax-free part of drawing from a defined contribution pot, and standalone lump sums. The lump sum and death benefit allowance is £1,073,100 and also counts serious ill-health lump sums and some lump sum death benefits paid to your beneficiaries. Anything above the relevant allowance is taxed at your marginal rate.

You add up lump sums from every pension you hold, across all schemes. Ask each provider how much of the allowances you have already used. The old lifetime allowance was abolished on 6 April 2024, and if you hold a protection certificate your allowance may be higher. The LGPS site notes that most of its members will not be affected, because the lump sum they can take is much lower than the limits.

How the lump sum arises in each scheme

The automatic lump sum and the choice to swap pension for cash are separate things, and which you have depends on the scheme and when you built up the service.

In the NHS Pension Scheme, members of the 1995 Section, and those who moved to the 2008 Section, get a lump sum automatically when they retire. Members of the 2008 Section and 2015 Scheme can ask to take some pension as a lump sum. NHSBSA says the exchange is £12 of lump sum for every £1 of annual pension you give up, and that the limit is 25% of the capital value of your benefits after commutation. The reduced pension does not change what the scheme would pay a dependant.

In the Local Government Pension Scheme, you get £12 of lump sum for every £1 of annual pension you give up. If you were a member before 1 April 2008 you will also have an automatic lump sum built up. The LGPS site says that once you have chosen, you cannot change your decision, and you cannot swap after your pension is being paid.

In the Civil Service alpha scheme, the rate is also £12 for every £1 of pension, with a maximum set by HMRC rules. Classic members who were in the old schemes usually keep an automatic lump sum of three times the classic pension, and the scheme says any lump sum from classic, premium, classic plus, nuvos or alpha is tax-free unless you breach the lump sum allowance. Teachers’ Pensions publishes its own lump sum rules for the Teachers’ Pension Scheme; its member pages were unavailable when this page was checked, so read the current version on the teacherspensions.co.uk site before relying on any figure for that scheme.

A worked example

Say your NHS 2015 Scheme pension is £10,000 a year and you swap £1,000 of it. You give up £1,000 a year and receive £12,000 as a lump sum, paid without tax if it is within your allowance and within the 25% limit. Your annual pension falls to £9,000. The figures are hypothetical and the real maximum depends on your own benefits, so use the scheme’s quote when you claim.

When tax does apply

If you take more than your allowance, the excess is taxed. GOV.UK warns that taking a large amount could push you into a higher tax rate and leave you owing extra at the end of the tax year. Pension cash drawn in other ways, such as a defined contribution pot, is taxed as income apart from the 25% tax-free part.

Small pensions have their own rules. A pension worth up to £10,000 can usually be taken in one go as a small pot lump sum, with 25% of it tax-free. If all your private pensions are worth £30,000 or less, a defined benefit scheme may allow a trivial commutation lump sum. If you have already accessed the pension, the whole of that lump sum is taxable.

Arrears and recalculation

Money your provider pays you in arrears from earlier years can temporarily push you into a higher bracket. You can ask HMRC to recalculate by sending the written breakdown of what was owed for each tax year. If too much tax has been taken, HMRC refunds it. For a wider picture of what drives tax on contributions, the annual allowance guide explains the other limit.

Before you choose, ask the scheme for a written estimate showing the pension and lump sum at your chosen date. A financial adviser can help with the decision.