One of the most attractive features people find when saving into a pension is the option of drawing a tax-free lump sum in retirement.
Personal pension plans generally allow you to withdraw 25% of the value and occupational pension schemes may even allow you to draw more, both of which provide a valuable boost to your retirement plans.
Just because this is the default option, however, is this the best solution for you? Under current HMRC rules, you can draw your pension in any manner you choose, providing you are over the current minimum retirement age of 55.
This guide will look at the pros and cons of taking your lump sum and how it can fit in with your wider financial planning strategy.
What would I use my tax-free cash for?
A lump sum can be extremely useful when you retire. Reasons might include:
- Clearing any outstanding debt.
- Home improvements or changing the car
- Making gifts to family
- Taking the holiday of a lifetime
One misconception though is that you don’t actually need to retire to withdraw your lump sum. If you are over 55 and don’t plan on retiring, for say another 10 years, you can still withdraw your lump sum now.
In doing that of course, you will have less money in your fund at retirement, and you should always think carefully about withdrawing money from your pension for this reason. Bearing in mind pensions are very efficient in terms of inheritance tax planning, if you have cash or other assets available, it may be more tax efficient to spend that money first.
Conversely, if you are retiring, this doesn’t mean that you have to take your lump sum at the same time.
Many people withdraw their tax-free cash lump sum for a specific reason; however, arguably, if you don’t need the money immediately then it is usually better to leave the funds to hopefully grow in your pension rather than earning little or no interest in a bank account.
Phasing the withdrawal
If you are looking to withdraw a lump sum from your pension, you don’t have to take it all at once. You can stage withdrawals over a number of years, either on their own or combined with pension income. In doing this, you can potentially benefit in the following ways:
- You can vary the amount you withdraw as needed
- You can use the money to supplement your income without increasing your tax bill
- Your remaining pension fund will continue to grow, potentially increasing the amount that you can withdraw later
This can often be a very good option if you don’t actually need a lump sum but want to generate a tax efficient income.
Investment options
To add to their tax efficiency, monies invested in a pension generally go free of most taxes. This, combined with tax relief on your contributions and the tax-free cash available at 55, make pensions one of the most tax efficient investments available.
If you do withdraw your lump sum, you can of course reinvest the money and, depending on market fluctuations, it should continue to grow in value.
This does mean, however, that the fund will be taxed like any other investment, and apart from your annual ISA allowance of £20,000, any other funds placed outside an ISA or a pension will be subject to tax on any interest, dividends or capital gains generated.
In the current market, there are very few legitimate regulated investments that you can’t access within a pension, and therefore if you are considering taking your lump sum to invest elsewhere, moving your pension fund could allow you to do this without unravelling the beneficial tax treatment.
Passing on wealth
As we know, most pension funds are not included within your estate for inheritance tax purposes. Your pension can be passed on to your beneficiaries free of any tax if you die before age 75. If you die after age 75, your beneficiaries can withdraw your pension as an income and will be taxed at their own marginal rate.
Many people look to make gifts during their lifetime and taking your tax-free lump sum is one way of potentially funding this. Withdrawing the money from your pension however places it in your estate and potentially increases your inheritance tax liability, and even when you give the money away, it remains in your estate for seven years.
It is generally more efficient to use other assets first when making lifetime gifts (e.g. investment funds or cash), meaning that your pension fund can continue to grow tax efficiently outside of your estate.
Continuing with contributions
If you do decide to take taxable income from your pension, this automatically triggers the Money Purchase Annual Allowance (MPAA), which restricts further contributions to £4,000 per annum (gross).
Withdrawing the tax-free lump sum from your pension, however, does not trigger the MPAA, which means you can continue making potentially higher contributions.
There are, however, rules around ‘recycling’ tax-free cash to stop people receiving double tax relief, with the following being classed as recycling of contributions:
- If the recycling is pre-planned
- The lump sum is over £7,500
- The contributions have increased by 30% or more
- The contributions comprise more than 30% of the lump sum
Recycling of tax-free cash can result in what is known as an ‘unauthorised payment charge’ being applied to your lump sum, which can be up to 55%, as well as potential sanctions on the pension scheme.
Defined Benefit schemes
This guide is mainly looking at money purchase arrangements, which allow you to flexibly withdraw generally 25% of the fund value.
Defined Benefit schemes, otherwise known as final salary schemes, work differently as once you choose your retirement options you cannot change your mind later. Generally, these schemes have a pre-determined retirement date and permission must be granted by the scheme trustees if an individual wants to mature their benefits either before or after this point.
You may be offered a lump sum under the scheme rules or you might need to give up some of your income in exchange for a lump sum. This can generally be quite a complex decision and will depend on your circumstances, requirements and the rules of the scheme.
Pensions freedom mean you have more options however around how you take your benefits, and your adviser can help create a retirement strategy that works for your lifestyle, goals and tax situation.