Are small pot pensions better than merging them?

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This post was originally published in June 2022. It was updated in July 2024.

A little while ago, I wrote about whether you should be merging your pension pots.

There are definite benefits, like making your pensions easier to keep track of and manage, and saving on costly fees.

But there’s actually a lesser known “small pot lump sum pension” rule that might mean in some cases, it’s better to keep your pension pots small.

Like other pensions related stuff, it’s not the most straightforward rule to understand.

So I got two pensions experts – Joel Stevens-Leach, a financial advisor from Dane Valley Financial Services, and Romi Savova, CEO of PensionBee – to help explain how it all works.

What is the small pot lump sum rule?

The small pot lump sum rule is also known as the small pot pensions rule or the small lump sum rule.

It basically allows you to cash out any pension under £10,000 as a single lump sum when you reach 55, rather than in stages.

You can do this for three personal pensions, or an unlimited number of different workplace pensions.

The first 25% of the lump sum will be paid to you tax free, and you’ll pay income tax on the remaining 75%.

The amount of income tax you pay here will depend on which tax bracket you’re in.

However, because the money counts as income, if you’re still working then cashing out your pension as a lump sum could actually push you into a higher tax bracket.

Are there any benefits to cashing out your pension this way?

The main benefit is that taking any pensions via small pots will not trigger the Money Purchase Annual Allowance (MPAA). 

“This means that savers can continue to contribute up to the full annual allowance and may benefit from further tax relief on their savings,” says Savova.

Each year, you can pay up to £60,000 into your pension – or the entirety of your income, whichever is lower – and receive tax relief on that contribution.

But when you trigger the MPAA, you’ll only be able to pay in £10,000 a year and still get tax relief.

So if you’re working well into your retirement and still want to top up your pensions – and get tax relief on that money – you’ll be limited on how much you can put in if you cash a larger pension.

Should you merge your pensions or leave them as small pots?

One of the benefits of a smal pot pension was that it didn’t count towards your lifetime allowance for pensions.

But since the lifetime allowance was scrapped starting from the tax year April 2024, this benefit has evaporated with it.

So if you do have small pots, it might be better to merge them to save on fees and reduce the number of pensions you have to manage.

How does it work if you also have a larger pension pot? 

“The larger pension funds will be accessed in the normal way,” says Stevens-Leach. 

That means all the usual taxes and limits apply. 

There are a few different ways you can withdraw your main pension though.

Once you reach pension age, you can get free pension advice from the government through Pension Wise to help you decide what’s best for you – including whether it’s worth cashing out any small pots first.

Before that, you’ll need to pay to see a financial advisor who will be able to help you with pension planning.

This can be expensive, but it’s definitely worth doing if your pension is already pretty big.

A note on really small pensions.

A new rule came into effect in April 2022 that banned flat fees on small pension pots.

It only applies to pension pots that are worth £100 or less, but it still means a potential saving for those who have pensions from employers that they’ve only been with for a short amount of time.

It’s worth bearing in mind that management fees that are a percentage of the pension pot’s value may still apply and eat into your pension.

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