Updated: Jul 21
Coming up to retirement, it’s natural to get excited at the prospect of being able to take 25 percent of your pension as a tax-free lump sum. Having paid so much tax over the years, it’s great to finally get something back from the tax man. But taking a big pension lump sum might not always be the right thing to do. Here’s the argument for and against.
3 Reasons for Taking a Large Tax-Free Lump Sum
One. If you’ll need to pay higher rate income tax on your retirement income, it is generally more tax efficient to take advantage of a larger tax-free lump sum.
Two. You might value getting more of your pension money into family ownership sooner rather than later so that you can potentially avoid inheritance tax.
Gifts made to your children seven years or more before death are not assessed for inheritance tax. Before 7 years has passed after a gift is made ”taper relief” reduces the amount of your gift that is exempt. If you die within three years of or less before making a gift, the full amount will be assessed for IHT (Inheritance Tax).
Your children might find it difficult to meet any tax charge that arises, especially if they’ve already spent the money gifted to them.
A large lump sum will give you the cash to give away if you plan to reduce any future inheritance tax.
Three. It’s helpful to have extra income when you’re in a position to spend it.
Leaving the withdrawal of income from your pension until later will allow your fund to grow. However, you’ll likely want income to support hobbies and activities whilst you’re younger and more able to enjoy these pastimes. Taking the largest possible lump sum will allow you easy and uncomplicated access to the lifestyle you want whilst your pension funds are put to work in a well-managed portfolio of quality funds.
Over time, our clients’ activity levels will likely reduce and future lump sums that you take may well go unspent. Better to have the cash now when you need it.
3 Reasons for NOT Taking a 25 Percent Lump Sum
One. – Your future income may be put at risk if you sell assets to take a large tax-free lump sum when market prices are suppressed.
The reason for this may not be obvious on first inspection.
The issue is that if you crystallise any paper losses by making a withdrawal whilst markets are still low it will be difficult to recover your initial position.
Taking a 25% lump sum when markets are suppressed by 10% requires a 14.8% rebound in market prices to recover your initial position. Given this is unlikely in the short term, you could be left with a smaller pension pot than if you waited for prices to recover before taking your lump sum.
A smaller pension could harm your future income.
Two. – Money left in your pension can be passed to your kids tax-free.
Money left in private pensions can be bequeathed without incurring any inheritance tax. If you were to die before age 75 with less than £1.05 million in your pension, your beneficiaries would be able withdraw the whole amount without paying any tax. If you died later, they would just need to pay income tax on any withdrawals at their marginal rate.
In contrast, if you had gifted this same amount shortly before death, any inheritance tax assessed would be charged at 40 percent.
For a beneficiary who is a basic rate tax payer, receiving a £100,000 gift subject to IHT would create a tax liability of £40,000. However, if withdrawals were made gradually from the pension so as to keep his total income below the higher rate tax threshold the tax charge would only be £20,000.
Three. – Leaving the money in your pension will provide greater flexibility in the future.
By keeping your funds invested they will continue growing in a tax efficient manner throughout your retirement.
It may be appropriate for you to delay the purchase of an annuity which will make it much cheaper. Alternatively you might want to choose to take a tax-free lump sum at a later time when the market prices are higher.
The articles are for information only and should not be construed as advice or a recommendation. The investment strategies mentioned are examples only and may not be suitable for your particular: circumstances, tax position or objectives. Please seek independent financial advice before taking any action.
Names have been changed to protect identity.
No advice should be conferred from the articles. No action should be taken without independent professional financial advice as any actions on your pension may be irrevocable and have a big impact on your income in retirement.