Tax-Free Cash Explained: The 25% Pension Lump Sum and Its £268,275 Cap

The ability to take a chunk of your pension tax-free is one of the most well-known pension perks - and one of the most commonly misunderstood in the details. Here’s exactly how the 25% tax-free cash rule works, and where its cap comes from.

The basic rule

When you start drawing money from a defined contribution pension, you can normally take up to 25% of the value as a tax-free lump sum, with the rest available to draw as income (taxed at your marginal rate) or left invested. This can be taken as one lump sum when you first access the pension, or in smaller chunks over time as you draw down, depending on how your provider and product allow it.

Why there’s now a cap in pounds, not just a percentage

Since April 2024, the old ‘Lifetime Allowance’ system was replaced with two separate allowances, and the one that matters for tax-free cash is the Lump Sum Allowance (LSA), set at £268,275. This means the tax-free cash you can take across all your pensions combined is capped at 25% of their value, or £268,275, whichever is lower.

In practice, this cap only binds people with combined pension pots above roughly £1.07 million (since 25% of that is around £268,275) - for the substantial majority of savers, the 25% rule alone is what matters, and the cap is irrelevant.

The related death benefit allowance

A second, related allowance - the Lump Sum and Death Benefit Allowance (LSDBA), set at £1,073,100 - caps the total tax-free lump sums payable from your pensions across your lifetime and on death combined. This mainly matters for larger pension pots and estate planning, and interacts with the pension Inheritance Tax changes coming from April 2027 (see our separate articles on this).

Common ways people use tax-free cash

• Paying off a mortgage or other debt shortly before or at retirement.
• A one-off purchase - home improvements, a car, helping family with a deposit.
• Supplementing income in early retirement years, before other income (like the State Pension) kicks in.
• Reinvesting it elsewhere, such as into an ISA, for continued tax-efficient growth with more flexible access than leaving it in the pension.

A caution: taking it doesn’t always make sense straight away

There’s no requirement to take your tax-free cash the moment you’re able to (normally from age 55, rising to 57 from 2028). Taking it earlier than you need it means giving up further tax-free investment growth inside the pension wrapper, and some people are drawn to withdraw it pre-emptively based on rumours that the rules might change at a future Budget - a decision that can turn out to be unnecessary and costly if the rumoured change doesn’t happen (see our article on the upcoming Autumn Budget for more on this pattern).

Watch out for the Money Purchase Annual Allowance if you also want to keep contributing

If you take taxable income (not just the tax-free lump sum) from a defined contribution pension, it usually triggers the Money Purchase Annual Allowance (MPAA), cutting your annual allowance for further pension contributions from £60,000 down to just £10,000 a year. Taking only the tax-free cash, without touching the taxable portion, doesn’t trigger the MPAA - an important distinction if you’re still working and want to keep contributing to a pension after accessing part of another one.

The bottom line

For the vast majority of savers, the 25% tax-free cash rule - not the £268,275 cap - is what actually applies. Think carefully about timing rather than taking it automatically the moment you’re eligible, and be aware of the MPAA trap if you want to keep contributing to a pension after accessing another one.