Tempted to empty a small pension pot now but not sure if you can or should? We explore the rules around small pension pots and how much tax you might have to pay.
So how do small pension pots work? If you have changed jobs several times during your career, there is a chance you have accumulated a collection of small pensions. You might have £3,000 in an old workplace pension, £6,500 from another employer and perhaps a few thousand pounds in a personal pension you no longer contribute to.
These small pots can be easy to overlook, but they can add up to a sizeable amount of money. And if you are approaching retirement, it is worth understanding how the UK’s small pots pension rules work, and whether withdrawing your money from them now could be a good idea, or not.
What is a small pension pot?
A small pension pot is usually a defined contribution pension worth £10,000 or less that you may be able to take as a single lump sum when you become eligible to access your pension. (This is currently 55 but will rise to 57 in 2028.)
Under small pension pot rules you can take up to three small pot lump sums from different personal pensions, and unlimited small pot lump sums from different workplace pensions.
It’s important to remember that the £10,000 limit applies to each individual pension pot, rather than the total value of all your pensions.
So, for example, let’s say you have four pension pots:
- Pension 1: £3,000
- Pension 2: £6,500
- Pension 3: £8,000
- Pension 4: £38,000
The first three pensions, which are all individually worth less than £10,000, may qualify as small pots, even though your total pension savings are higher.
Why do people end up with lots of small pensions?
The introduction of pension auto-enrolment means it has become common for people to have multiple pension pots. Every time you change job, you leave your old workplace pension behind and start contributing to a new scheme. Throughout your career, this can mean you end up with five, six or even more pension accounts.
For this reason, it’s important to keep track of your pensions. If you aren’t sure whether you have any old pensions or not, or know you do but have lost the details, read this article and follow the steps to track them down.
Why are small pension pot withdrawals different?
The big benefit of the small pension pot rule is that you can withdraw your money without triggering the Money Purchase Annual Allowance (MPAA).
The MPAA is triggered if you take taxable money out of a defined contribution pension using a flexible payment option. This can happen when you:
- Start to take your pension as a series of lump sums
- Take a regular income using pension drawdown
- Take money from an investment-linked or flexible annuity
- Take your entire pension in one go
- Go over the cap on capped drawdown started before April 2015
Once you have triggered the MPAA, you are limited as to how much you can pay into your pension and still be eligible for tax relief. Under MPAA, your pension contributions must be less than, or equal to, the amount you earn, and contributions from both you and your employer must be less than £10,000.
Under small pension pot rules, withdrawing money from a small pension does not trigger the MPAA.
How much tax do you pay on a small pension pot?
Tax-wise, your small pension pots work in the same way as your larger ones, and they count towards your lump sum allowance. This means that 25% of your qualifying pension will usually be taken tax-free, and the remaining 75% is taxable as income.
So, of an £8,000 pension pot, for example, £2,000 could be tax-free and £6,000 would normally be taxable. That doesn’t mean you will necessarily pay tax on the £6,000; this will depend on your total taxable income for the tax year and your available allowances.
When should you take money from your small pension pots?
Given that 75% of your small pot pension will likely be taxable, it’s important to consider the timing of your pension withdrawals.
If you decide to take the money while you are still working, you could end up paying more tax than if you waited until you were retired, as it’s likely you will have used up your annual Personal Allowance. And, depending on your income, the money could be taxed at the Higher Rate or even Additional Rate.
That said, one of the benefits of small pension pots is that you can take the money out without triggering MPAA. This makes them a useful way of accessing some of your retirement funds while you are still working, and continuing to contribute to your pension.
Some people choose to take their small pension pots as they are approaching retirement and still working part time. The small pots give them an income boost, or pay for luxuries like holidays, while enabling them to continue adding to their pension.
Should you cash in your small pension pots now?
Just because you can cash in a small pension now does not mean you necessarily should. Here are some questions to consider before you take the money.
1. What do you need the money for?
Are you just taking the money because you can, or to boost your every day spending right now? Or do you have a specific need for it, such as home improvements, clearing debt or paying for a big bill? Perhaps you might even be using the money as part of a retirement bridge?
If the money is needed for a necessary purchase or bill, to pay off expensive debt or to enable you to retire earlier, you might decide to take the hit and withdraw it now. But if it will just be frittered away or spent on unnecessary purchases, consider whether you’d be better off leaving it invested and to hopefully continue growing.
2. What are the pension charges?
One thing to check before making a decision is your pension charges. If your pension has high charges, over time you could lose a significant proportion of its value to fees. In which case, you may decide that it’s worth taking the money now.
On the other hand, some older pensions may have valuable guarantees or benefits that you would lose by transferring or withdrawing them.
3. What is your money invested in?
Don’t assume that a small pension is automatically a poor pension – thanks to compound growth, even a modest pot can grow over time if invested in the right place.
For example, let’s say your pension pot is worth £8,000 today, you don’t contribute a penny more, and it grows by 5% a year. In 10 years time, your pot could be worth £13,031 – that’s a growth of £5,031.
So before you take your money now and spend it, check your investment fund, charges, performance and retirement options. And consider how much it might be worth to you in the future left where it is.
4. How much tax will you pay?
Before withdrawing your money, check what tax you might have to pay on it. What’s your total income for this tax year, or the year you plan to take the money? Work out what tax band your withdrawal might fall into, and how much tax you might have to pay on it.
If you have more than one pot, also consider whether you need to empty them all in the same year. If you are still working, withdrawing several small pots in the same tax year could push more of your income into a higher tax band.
Remember that if you wait until you are retired to withdraw the money, and your taxable income is relatively low at that time, the amount of tax you pay on it could be much less.
Don’t automatically consolidate everything
It can be tempting to combine all your pensions into one large pot. Consolidation can make your retirement savings easier to manage and could even reduce fees, but it is not automatically the best option.
Before transferring an old pension, check whether it has:
- Guaranteed benefits
- A guaranteed annuity rate
- Protected tax-free cash
- Special early-retirement benefits
- Valuable investment options
- Exit or transfer charges
A defined benefit or final salary pension needs particular care because transferring it can mean giving up a guaranteed retirement income.
Think carefully about what to do with your small pension pots
Small pension pots may seem insignificant, but several pots of £2,000, £5,000 or £9,000 can add up to a substantial amount of retirement savings. So think carefully before raiding your small pots and spending them now. By leaving them to grow you could end up with more money when you retire, and a smaller tax bill!
