Should you take your 25% tax-free pension lump sum?
The chance to pocket a tax-free 25 per cent lump sum from your retirement fund when you stop working is one of the most popular perks of saving into a pension.
Flush with cash on the brink of retirement, you can choose to treat yourself, be sensible and pay off debts, or show generosity to younger or older family members.
But there is another option – to not take the lump sum, but leave your pension alone to continue growing or provide a higher income over the course of retirement.
Unless you have a definite plan for your cash, this can be a more financially savvy decision than putting the money in a bank account to be ravaged by inflation and poor interest rates.
You will still get 25 per cent of your pot tax-free later on if you opt to withdraw it gradually in chunks. However, you lose the tax-free perk if you tie up your entire pot in an annuity or income drawdown scheme.
Meanwhile, deciding to wait means banking on the rules not changing - a big ask for some.
Fear of the Government abolishing the lump sum perk is the crux of the matter for many people, given how much politicians have meddled with pensions over the years
We look at what to weigh up when you are deciding to take some, all or none of your 25 per cent tax-free lump sum at retirement. And we discuss how likely it is the Government will scrap the tax break, and raid past savings or future ones.
How popular is the tax-free lump sum and what do people spend it on?
Some 54 per cent of workers plan to take a tax-free lump sum at retirement, according to a survey by pension giant Aegon.
It found people nearest to retirement, at age 55-65, have an average of £105,496 saved in their pension, meaning they could take up to £26,000 of tax-free cash.
When it comes to using that money, some 17 per cent plan to put it into a cash Isa, 15 per cent will stash it in a bank account, 14 per cent will take a holiday, 12 per cent are thinking about buying a property and 10 per cent intend to clear debts.
Steven Cameron, pensions director at Aegon, says: 'The ability to take up to 25 per cent of your pension tax-free has always been a popular option with retirees.
'The option is intended as an incentive to save through a pension and often allows people to fund the early part of their retirement and to make the most of their new-found freedoms.
'It’s particularly beneficial to those whose retirement incomes are likely to be above the tax-free annual allowance of £11,500.'
He added: 'Arguably the decision to take cash this way at retirement has become more complicated since the introduction of the pension freedoms.'
'Previously the majority of people took their cash and then bought an annuity with the remainder.
'Now people can access their savings in a variety of ways, including by keeping them invested and drawing an income, or by accessing it all as cash either in one or multiple goes.'
Should you take the 25 per cent tax-free lump sum?
Here's a rundown of what to consider beforehand.
1) Do you need the money?
People on the brink of retirement are not usually short of ideas on how to spend cash after they stop work.
The survey cited above reveals some of the most popular uses of the tax-free lump sum.
But it's another matter if you have no immediate plans for the money and just intend to move it to a savings or Isa account.
Unless you do, there are tax benefits to keeping your pension intact which are explained in more detail below.
People with defined contribution pensions, where workers and employers make contributions that are invested to build up a retirement fund, should also bear in mind any money not yet withdrawn could carry on growing – although of course, it might fall in value too.
'Retirees need to think carefully when deciding whether to take their maximum tax-free cash lump sum immediately or leave more of their money invested,' says Cameron.
'For some people the cash received is vital to clear debts, perhaps pay off a mortgage or clear a credit card. However, not everyone needs it as soon as they retire and money left invested in the pension will continue to grow tax-free while also offering beneficial inheritance tax aspects.
'Cash Isa rates and returns on savings accounts are at all-time lows, with the combination of inflation and low interest rates effectively eating away at spending power from these accounts.
'Yet, nearly a third of people plan to put the money in a cash Isa or a bank account and this raises a red flag.
'Savers have worked their whole life to put money away so should be wary of leaving it languishing in bank accounts which aren’t returning the favour. Delaying taking it until they really need it might be a more sensible option.'
Mark Stone, financial planning director at adviser Whitechurch Securities, says: 'Our view is that the tax-free lump sum is a very beneficial option for clients with a pension plan.
'However it is not always in a client’s best interests to take the lump sum at the outset, either in full or indeed sometimes at all.
'When we advise clients we always ascertain what they need the lump sum for to get a full understanding of their requirements to best advise them of their options.'
2) Will you end up paying more tax?
'A pension is still a tax efficient environment,' says Andrew Tully, pensions technical director at financial specialist Retirement Advantage.
Your 25 per cent lump sum comes tax-free and so won't affect your income tax rate when you take it, unlike the other 75 per cent of your pot. However, not withdrawing it keeps that money protected from inheritance tax, and allows you to carry on benefiting from tax-free growth if your investments perform well, he explains.
Cameron says: 'Carefully consider inheritance planning in any decisions about your pension savings. As soon as money is accessed it is then subject to inheritance tax as part of a person’s estate but pension savings are treated differently.
'If death occurs before age 75 pension savings can be passed on tax-free and if over age 75, tax is paid at the income tax rate of whoever inherits the pension pot.'
Meanwhile, you can still get 25 per cent of your pension tax-free if you decide to take it in phased withdrawals rather than in one go.
Cameron says: 'If you can keep the money invested in your defined contribution pension and take smaller amounts each year, you may be able to opt for 25 per cent of each of these payments to be tax-free and this has the added benefit that the remaining money will gain from any investment returns before you take it.
'You only have this option before you move your pension into an annuity or income drawdown product. Retirees thinking about this should check that their scheme or provider offers this and any associated fees.'
3) What kind of pension scheme are you in?
People with defined contribution pensions can continue to benefit from tax-free investment growth on the portion of their pot they have not yet withdrawn. And they still get 25 per cent of their pension tax-free when taking it bit by bit, as explained above.
But those with final salary, also known as defined benefit, pensions are in a different situation.
Tully explains that if you are still active in a final salary scheme and your savings grow, so will the amount of tax-free cash you can get. But once you have left a scheme your savings won't grow hugely, except in some cases they could benefit from a revaluation, for example via inflation.
Also, the tax-free lump sum offers made by final salary schemes when members begin retirement can vary widely and you need to take this into account.
How it works is that you are allowed to take anything up to 25 per cent tax-free. But the bigger the lump sum you withdraw, the more future pension you sacrifice – and some schemes force you to forfeit more than others.
What you give up is down to the 'commutation factor'. For example, you might be offered £12 in the form of a lump sum for every one pound of future pension you give up. This is a commutation factor of 12:1. But some schemes will offer you £20 of lump sum for every pound of pension income you sacrifice. That would be a far more favourable commutation factor of 20:1.
Tully says: 'This is where people really need advice. If it's a poor commutation factor you might be better taking more as income and less as tax-free cash.
'But if you want to pay off debt, it might be better to take the lump sum even if it's a poor commutation factor. Or another option would be to take tax-free cash from a defined contribution pot, and none from a defined benefit pot. It's difficult to say one course of action is always favourable. It depends on your circumstances.'
When it comes to judging whether your commutation factor is any good, Tully says: 'Anything below 15:1 is poor in today's environment. Anything above 20:1 is good, 15:1 to 20:1 is OK - I would think not great but acceptable,'
This is Money columnist Steve Webb recently replied to a reader who asked why his wife's 25 per cent tax-free lump sum deal from a final salary pension was so miserly, and his own much more generous.
Steve agreed the wife's offer was poor and warned other final salary scheme members not to simply sign up for the tax-free lump sum they are offered without doing the maths and asking some searching questions first. Read more here.
4) Do you have a 'protected' lump sum?
'You may be entitled to a higher"protected" percentage tax-free from some older types of pensions – check with your provider or scheme,' says Cameron. 'This may affect how you decide to take your tax-free cash sum.'
Is the Government likely to scrap tax-free lump sum?
Three pension experts gave their views on the likelihood of the Government axing this popular tax perk for people on the brink of retirement, and all downplayed the prospect.
Andrew Tully of Retirement Advantage says: 'I think it's unlikely to be changed. It's a perennial rumour for every Budget for the last 10 years. It's such a popular benefit that it would be a brave move by any Government.'
He explains that there would be big practical challenges. It would cause such a backlash to scrap the tax-free lump sum perk retrospectively - meaning on all pension savings built up before the day the axe fell - that the Government could probably only get away with doing it for any funds built up from that point onwards.
But getting rid of it for future savings only would effectively split everyone's pension pots in two, before and after the date the rules were changed, for the purposes of calculating the tax-free lump sum.
Tully reckons the only way the Government could get away with this politically would be to axe tax-free pension cash for any sum over £100,000, so it would just hit the wealthiest savers
Yet it would still be difficult to apply this retrospectively to existing retirement savings, so the same 'double pot' issue outlined above would occur, but only affect the better-off.
Any change would also probably have to be announced and take effect immediately, because if there was a run-up period people would seize the chance to pile as much cash as possible into their pensions before the cut-off date.
'I think you can always do it. Would it be complex? Absolutely. Would it be easy? No, it wouldn't,' said Tully. 'I can't stand here and say it will not be done. I do think it's unlikely anytime soon.'
Steven Cameron of Aegon says: 'There’s always the chance that the Government of the day can change the tax breaks for pensions.
'But any changes which apply retrospectively, for example reducing tax-free lump sum entitlements already built up, would be very surprising and hugely controversial.
'Previous Government consultations on pensions tax relief have focused on potential changes to the tax relief granted on future contributions, for example by making these less generous for higher rate tax payers.'
Mark Stone of Whitechurch Securities says: 'As they say, nothing is guaranteed. However when pension freedoms were announced the lump sum was confirmed as part of the pension landscape and therefore we do not believe that it will be immediately withdrawn and therefore some of the comments around this could be seen as scaremongering.'
Should you move pension cash to an ordinary account?
Financial experts warn against the common practice of moving money from pension pots to cash Isas and bank accounts.
This is because you are transferring it from a pot which can still grow unfettered by tax to a place where it will lose value over time due to inflation and poor interest rates.
What is pension freedom?
Pension freedom reforms have given over-55s greater power over how they spend, save or invest their retirement pots.
Key changes from April 2015 included removing the need to buy an annuity to provide income until you die, giving access to invest-and-drawdown schemes previously restricted to wealthier savers, and the axing of a 55 per cent 'death tax' on pension pots left invested.
The changes apply to people with 'defined contribution' pensions which invest them to provide a pot of money at retirement.
They don't apply to those with more generous and guaranteed final salary pensions.
However, those still saving into such schemes can transfer to DC schemes, provided they get financial advice if their pot is worth £30,000-plus.
What do people take the 25% tax-free lump sum?
A behavioural study of over-55s with pots worth £30,000 to £100,000 found the vast majority of those who accessed retirement saving after pension freedoms took their 25 per cent lump sum.
But the research published last year revealed that this was more of a behavioural response to the tax rules than a considered decision about the best use of the money and whether they would need it in retirement.
Many assumed they would lose the tax benefit if they didn't take 25 per cent immediately. There were fears their pot would ‘mature’ or be neglected, or the Government would take away the option.
How to final salary and defined contribution salaries work?
Defined contribution pensions, sometimes called money purchase in industry jargon, take contributions from both employer and employee and invest them to provide a pot of money at retirement. More generous gold-plated defined benefit or final salary pensions, provide a guaranteed income after retirement until you die.
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