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Should you Take Your 25% Tax-Free Pension Lump Sum?

Updated: Jan 12

Deciding if you should take your 25% tax-free pension lump sum can be difficult. However, one of the most popular perks of saving into a pension is having the option to pocket 25% tax-free cash when you stop working.

Many of our clients have already decided how they are going to spend their lump-sum by paying off a mortgage, luxury holidays, camper-vans- the list is endless!

Before you indulge in what the money can buy you, there is another option, not to take the lump sum.

You could leave your pension alone to continue to grow to provide a higher income over the course of retirement.

Unless you have a definite plan for your cash, this can be a wise decision. You are still able to get 25% of your pot tax-free even if you opt to withdraw gradually in smaller amounts. You will lose the tax-free perk if you tie up your entire pot with annuity or income drawdown scheme.

Things to Consider:

1. Do you need the money?

For some people, the tax-free cash is vital, as they are able to pay off any debts such as their mortgage. However, not everyone needs this lump sum as soon as they retire, and money left invested in the pension will continue to grow tax-free while also offering beneficial inheritance benefits.

2. What impact will it have on your comfort in retirement later?

When you take the money out of your pension, you don't just lose the initial value of your withdrawal you also lose the growth that the money would have generated had it remained invested.

3. What kind of pension scheme do you have?

Members of Defined Contribution pensions can continue to benefit from tax-free investment growth on the portion of the pot they have not withdrawn. They will still be able to withdraw 25% of the pension tax-free when taking it in smaller amounts.

Those with a Defined Benefit Pension Scheme are in a different position. If you are still active in your scheme and your savings grow, so will the amount of tax-free cash you get. Once you leave your savings (or in this case your income in retirement) will grow in line with inflation (usually either RPI or CPI to a maximum of 5% for example). The tax-free lump sum offers made by final salary schemes can vary- you will need to take this into account.

4. Will you end up paying more tax?

Taking your 25% lump sum is tax-free and won't affect your income tax rate when you take it, unlike the remaining 75% of your pot. Not withdrawing your pension keeps your money protected from inheritance tax and allows you to carry on benefiting from tax-free growth- if your investments perform well.

You should consider inheritance planning in any decisions about your pension as when the money is accessed it is subject to inheritance tax as part of a person's estate. If death occurs before age 75 pension savings can be passed on tax-free if over the age of 75 tax is paid at the income rate of whoever inherits it.

If you decide to take your pension in phased withdrawals rather than in one go you can still get 25% of your pension tax-free. 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% of each of these payments to be tax-free.

5. Will the Government change the rules?

The fear of the Government abolishing the lump sum perk is the core of the matter for many people- given how many politicians have changed pension rules over the years. The ability to take 25% of your pension tax-free has always been popular with retirees. It is intended as an incentive to save through a pension and often allows you to fund the early part of retirement.

It is particularly beneficial to those whose retirement income is likely to be above the annual allowance of £12,500 (2019/20 tax year).

Previously, the majority of people took their cash and bought annuity with the remainder. Now, the decision to take the cash this way at retirement has become more complicated since the introduction of pension freedoms. People can access their savings in a wide variety of ways, including keeping them invested or drawing income, or by accessing it all as cash either in one or multiple goes.

'I don't want to take my lump-sum all at once, what do I do?'

This is common for many of our clients who do not necessarily need to take out the tax free cash. There are a number of options to consider:

  • Leave it invested in your pension for when you need it, when you decide to withdraw the cash you will receive 25% tax free cash from each lump sum you withdraw.

  • Take 25% tax-free cash, then buy a flexible drawdown product. This is different as you only get taxed on the remaining funds when you withdraw- this usually keeps you in a lower tax bracket.

  • Take 25% tax-free cash, and then buy annuity which provides a secure income for life.

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.

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