Stacking coins

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 – although you might not necessarily want to do it right now.

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 can be known as the small pot pensions rule or the small lump sum rule.

It basically allows you to cash out three personal pensions (ones you’ve set up yourself, rather than through an employer) up to the value of £10,000 each as a lump sum when you reach 55.

You have to take out all the money in one go, rather than in stages, as otherwise you may be liable for additional tax.

The first 25% of this 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 but because the money counts as income, if you’re still working then taking out this lump sum could actually push you into a higher tax bracket.

You can also do this for an unlimited number of workplace pensions (known as trivial commutation) but, Savova warned: “The limit for workplace pensions differs, so savers must check with their scheme provider prior to withdrawal.”

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

Yes! There are two main ones.

Small pots and pension lifetime allowance

“Taking a pension via small pots does not use any of your lifetime allowance,” according to Stevens-Leach. “If someone was close to/had fully utilised their lifetime allowance, it is a great way to access smaller pots without leading to a lifetime allowance tax charge.”

The pension lifetime allowance is currently £1,073,100 and is frozen until 2026.

This is basically the amount of money you can have in all of your pensions combined that will still allow you to withdraw part of it tax free. 

If you go over your allowance, tax is applied on everything you withdraw, which can end up costing you quite a lot of money.

The pension lifetime allowance might sound like a lot of money – and it is – but you have to bear in mind that this is the sum you save over a lifetime and includes any gains through investments, which if you’re lucky can be substantial.

Small pots and Money Purchase Annual Allowance

Another 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 £40,000 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 £4,000 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 severely limited on how much you can put in if you cash a larger pension.

Should you merge your pension pots now or cash them out later as a small pot?

“This very much depends on whether you have a lifetime allowance issue or are expected to have one,” says Stevens-Leach. 

“If you will never/are unlikely to exceed the lifetime allowance, then it would be better to merge them, reducing fees and benefiting from ongoing management of a single pot.”

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 this year 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.

However, 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.