One of the main advantages of saving into a pension is the option of a lump sum when you retire. Under current rules, most pension schemes allow you to withdraw 25% of the value as a tax-free lump sum. Some older-style occupational plans might allow you to take even more. This can provide a valuable boost to your retirement plans.
But just because this is the default option, is it the best solution for you? You can draw your pension in any manner you choose, providing you are over the minimum retirement age (currently 55, although rising to 57 by 2028).
In this guide, we look at the pros and cons of taking your lump sum and how it can fit in with your wider financial strategy.
What Do You Need the Money For?
A lump sum can be extremely useful when you retire. Reasons might include:
- Paying off your mortgage
- Undertaking home improvements
- Helping family
- Taking the holiday of a lifetime
But you don’t actually need to retire to withdraw your lump sum. If you are 55 and don’t plan to retire for another 10 years, you can still withdraw your lump sum now.
Of course, this means that you have less in the pot to fund your retirement. You should always think carefully before withdrawing money from your pension. If you have cash or other assets available, it can be more efficient to spend that money first.
Similarly, just because you are retiring doesn’t mean that you have to take your lump sum.
Withdrawing your 25% lump sum can be a good idea if you have a specific reason for needing the money. If you don’t have a purpose in mind, it’s usually better to leave the money to grow in your pension fund rather than earn minimal interest in a bank account.
Phasing the Withdrawal
You don’t have to take your lump sum all at once. Instead, you can stage it over a number of years, either on its own or combined with pension income. This has the following advantages:
- You can use the money to supplement your income without increasing your tax bill.
- You can vary the amount you withdraw as needed.
- Your remaining pension fund will continue to grow, potentially increasing the amount that you can withdraw later.
This can be the ideal option if you don’t actually need a lump sum, but want to generate a tax-efficient income.
Investment Options
Money invested in your pension fund grows free of most taxes. This, combined with tax relief on your contributions and the option to take a tax-free lump sum, makes pensions one of the most tax-efficient investment choices available.
If you withdraw your lump sum, you can re-invest the money. Depending on fluctuations in the market, it should continue to grow in value.
But this means the fund will be taxed like any other investment. You can place £20,000 per year in an ISA. However, any funds outside your ISA or pension will be subject to tax on interest, dividends, or capital gains.
In the current market, there are very few legitimate, regulated investments that you can’t access within a pension.
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
Currently, pension funds are not included in 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.
If you want to make gifts during your lifetime, taking your tax-free lump sum is one way of funding this. However, withdrawing the money from your pension places it in your estate, potentially increasing your inheritance tax liability. Even when you give the money away, it remains in your estate for seven years.
It’s usually more efficient to use other assets first when making lifetime gifts, such as cash or investment funds. This means that your pension can continue to grow tax-efficiently outside your estate.
Continuing with Contributions
If you take taxable income from your pension, this triggers the Money Purchase Annual Allowance (MPAA), which restricts future contributions to £10,000 per year (gross).
Withdrawing a lump sum does not trigger the MPAA, which means you can continue making higher contributions.
However, there are rules around recycling tax-free cash to prevent people receiving double tax relief. Contributions may be classed as recycling if all of the following occur:
- The lump sum is over £7,500
- Contributions have increased by 30% or more
- The contributions comprise more than 30% of the lump sum
- The recycling is pre-planned
Recycling tax-free cash can result in unauthorised payment charges being applied to your lump sum. This can be up to 55%, as well as sanctions on the pension scheme.
Defined Benefit Schemes
This guide is mainly concerned with money purchase pension schemes, which allow you to flexibly withdraw 25% (or more) of the fund value.
Defined benefit schemes work differently, as once you choose your retirement options, you cannot change your mind later. 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 be a complex decision, and will depend on your circumstances, requirements, and the rules of the scheme.
Pension freedoms mean that you have more options than ever around how you take your pension benefits. A financial planner can help you create a retirement strategy that works for your lifestyle, goals, and tax situation.
Please don’t hesitate to contact a member of the team to find out more about retirement planning.
