The phrase "small pots loophole" has been doing the rounds for a couple of years, usually with the words "free money" somewhere nearby. The rule is real and occasionally useful. It is also taxed, and the tax is not the flat 20% or 40% most explanations stop at. Here is what it actually does, what it costs at your income, and who should bother.
What the rule actually is
A pension pot worth £10,000 or less can be taken as a single cash lump sum from normal minimum pension age, which is 55 now and rises to 57 on 6 April 2028. You can do this with up to three personal pension pots in your lifetime, so £30,000 in total. A quarter of each payment, £7,500 across the three, is free of income tax. The remaining £22,500 is taxed as pension income in the year you take it, stacked on top of everything else you earn.
Occupational schemes are treated separately: a small lump sum from one of those does not count towards the three, but it does extinguish your rights in that scheme.
What it costs, by income
Because the taxable £22,500 sits on top of your other income, the bill depends entirely on what else you earned that year. Taking all three pots in one tax year:
| Other income | Tax on the £30,000 | You keep | Effective rate |
|---|---|---|---|
| Nothing | £1,986 | £28,014 | 6.6% |
| £30,000 | £4,946 | £25,054 | 16.5% |
| £60,000 | £9,000 | £21,000 | 30.0% |
| £100,000 | £13,500 | £16,500 | 45.0% |
| £150,000 | £10,125 | £19,875 | 33.8% |
The odd row is £100,000. The taxable £22,500 runs straight through the band where the personal allowance is withdrawn, so it is charged at an effective 60%, and the bill is £3,375 higher than for someone on £150,000 taking exactly the same money. If you are anywhere near that band, the 60% trap applies to this withdrawal as much as to a bonus.
Where the loophole is, and what it is worth
None of the above is the loophole. The loophole is what does not happen. Taking money out of a pension in the normal flexible way triggers the money purchase annual allowance, which cuts the amount you can pay into pensions each year from £60,000 to £10,000. A small pot lump sum is specifically not a trigger event. So you get £30,000 of cash and keep £50,000 a year of contribution headroom you would otherwise have lost.
That headroom is only worth something if you fill it. Someone on £60,000 who goes on to contribute the full £50,000 saves £11,432 in tax on it; someone on £100,000 saves £19,946, because their contributions also rescue the personal allowance. Set against the tax paid on the withdrawal, the break-even is roughly £35,300 of further contributions at £60,000 and £33,800 at £100,000.
The loophole is a loan against your own allowance. You pay the tax now, and only come out ahead if you genuinely have tens of thousands to put back in.
Who this is actually for
Someone still earning well, with a few stray pots from old jobs, who wants the cash for a specific purpose and fully intends to keep making large pension contributions for years. For them the rule does exactly what it says: cash now, allowance preserved, and salary sacrifice carries on untouched.
It is not for someone who wants the money because they need the money. If you were never going to contribute more than £10,000 a year again, the allowance you are protecting was headroom you would not have used, and what remains is simply a taxable withdrawal that, at most incomes, would be cheaper in a year when you earn less.
The full workings, including the curve of the effective rate across every income, are in our small pots research note. If your income sits between £100,000 and £125,140, run it through the 60% tax trap calculator first.
Three ways it goes wrong
- Taking three pots in one high-earning year. The tax is set by that year's income. Spreading the three across years, or taking them in a year off, changes the bill more than anything else you can do.
- Consolidating first. Merging your old pots into one tidy pension is usually sensible, and it destroys this option, because a pot over £10,000 no longer qualifies. Decide before you consolidate, not after.
- Assuming the 25% is the whole tax story. The tax-free quarter is real, but the other three quarters are income, and they count towards the Child Benefit charge and the personal allowance taper like any other income would.
If you are not sure whether protecting the allowance is worth anything to you, the AI Wealth Assistant will tell you where pension contributions sit in your own order of priorities before you take anything out.