How the tax-free quarter of a pension works, and how the rest is taxed

Ask people what they know about their pension and the tax-free lump sum usually comes up first. It is the part of the rules that most people have heard of, and plenty of plans for the early years of retirement are built around it: a new kitchen, clearing the last of the mortgage, help for a grown-up child.

What gets less attention is the other three quarters. That money is taxed as income, at your usual rates, in the tax year you take it. How much tax you pay can depend as much on when and how you draw it as on the size of the pot.

The tax-free quarter

GOV.UK explains that you can usually take up to 25% of the money built up in a defined contribution pension as a tax-free lump sum. Its formal name is the pension commencement lump sum. The rest is taxable, and tax is taken off before the money reaches you.

This article covers defined contribution pensions, where you build up a pot. Defined benefit pensions also usually allow a tax-free lump sum, but it is calculated differently and normally reduces the pension paid each year.

The cap that replaced the lifetime allowance

The lifetime allowance, which used to limit the total pension savings that could be built up without an extra tax charge, was abolished from 6 April 2024. Two new limits apply instead:

£268,275 is a quarter of £1,073,100, the old lifetime allowance. For most savers the cap is far away. It matters mainly for very large pots or people with several large pensions.

Two ways to take the tax-free part

There are two common routes, and the difference is in the timing.

• All at once. You take up to 25% as a single tax-free lump sum and move the rest into drawdown, where it stays invested, or use it to buy an annuity. You pay income tax only on what you take from the remaining 75% later.
• A slice of each withdrawal. With an uncrystallised funds pension lump sum, often shortened to UFPLS, you take money in chunks and each payment is generally 25% tax-free and 75% taxed. Take £20,000 this way and £5,000 is tax-free, with £15,000 added to your income for the year.

Not every scheme offers both, and moving to one that does is a decision with its own checks, covered in our guide to pension transfers.

How the other 75% is taxed

Taxable pension money is added to your other income for the tax year, including any State Pension, earnings and rental income, and taxed through PAYE at your marginal rate. For 2026/27 in England, Wales and Northern Ireland the bands are:

• Personal Allowance: the first £12,570, taxed at 0%;
• basic rate: £12,571 to £50,270, at 20%;
• higher rate: £50,271 to £125,140, at 40%;
• additional rate: above £125,140, at 45%.

The Personal Allowance is reduced by £1 for every £2 of income over £100,000. The government confirmed in November 2025 that the Personal Allowance and the basic rate limit will stay at these levels until 5 April 2031. Scotland sets its own income tax bands, with six rates from 19% to 48%, so Scottish taxpayers should use those figures instead.

A worked example: spreading or taking it at once

Illustrative example

Ann, 64, lives in England and has a £100,000 pot and £12,000 a year of other taxable income. She takes £25,000 tax-free, leaving £75,000. Invented figures, 2026/27 rates, ignoring investment growth and future rate changes.

Option A: draw £75,000 in one tax year

Total taxable income (£12,000 + £75,000)£87,000

20% on £37,700 basic-rate band−£7,540

40% on £36,730 above £50,270−£14,692

Income tax for the year£22,232

Option B: draw £15,000 a year for five years

Taxable each year (£27,000 − £12,570)£14,430

20% each year−£2,886

Income tax over five years£14,430

Illustration only. Real outcomes depend on investment returns, other income, future tax rules and what the money is needed for.

In this invented case, drawing the same £75,000 over five years rather than one keeps it all in the basic-rate band and means about £7,800 less income tax. Spreading is not always possible or sensible, but the arithmetic shows why the timing is worth discussing before acting. A free Pension Wise appointment covers exactly this.

The emergency tax on a first withdrawal

When you take taxable money flexibly for the first time, the provider often has no up-to-date tax code for you. HMRC’s guidance is that it then uses an emergency code on a “month 1” basis, which treats a one-off payment as if it would be repeated every month. The result is often too much tax taken at first.

The overpayment is not lost. It is usually corrected through PAYE later in the year, or you can reclaim it sooner with the form that fits your situation: P55 if you have not taken the whole pot, P50Z if you have taken it all and have no other income apart from the State Pension, or P53Z if you have taken it all and have other employment or pension income. If you file a tax return, the figures also appear there; see our guide to the January Self Assessment bill.

What it can mean for paying back in

Taking only the tax-free lump sum does not affect how much you can pay into pensions. Taking taxable money flexibly does. The first payment of income from drawdown or the first UFPLS triggers the Money Purchase Annual Allowance, which limits tax-relieved contributions to defined contribution pensions to £10,000 a year. That matters for anyone still working and paying in.

Looking ahead

The Finance Act 2026 brings most unused pension funds and death benefits into a person’s estate for inheritance tax for deaths on or after 6 April 2027. This does not change the tax-free lump sum during your lifetime, but it may affect how families think about leaving money in a pension.

Who this matters for, and what to check

• Anyone with a defined contribution pension who is planning to take money in the next few years.
• People still working, who should consider the £10,000 Money Purchase Annual Allowance before taking taxable income.
• Anyone thinking of using a lump sum to help family; our guide to everyday gifts and inheritance tax sets out the exemptions.
• People with older plans, who should ask whether they have protected tax-free cash above 25%.