23rd March 2023
general
There are many things to consider when you are approaching retirement – for example, how will you spend your money, and what will you do with your time?
One of the main benefits of a pension is the option to take a 25% tax-free lump sum. This can provide flexibility when you retire. Perhaps you want to spend money on home improvements, travel, or make gifts to your family. Or maybe you would just like the security of some extra cash to draw on as you wish.
In this guide, we look at the options for your lump sum and the factors to take into account when you are deciding how to take your pension benefits.
A Brief Guide to Your Retirement Options
Currently, you can take retirement benefits at any time from age 55. This is increasing to 57 and will ultimately remain 10 years below the State Pension age.
In most cases, you can withdraw 25% of your pot as a tax-free lump sum. This can be taken all at once or phased over a number of years.
The remaining fund is designated to provide income, which will be taxable at your marginal rate. You can either withdraw money directly from the fund as required, or use your pot to buy an annuity, which offers a guaranteed income for life.
You don’t have to actually retire to take benefits from your pension. There are many reasons why you might want to withdraw some money while you are still working. However, if you take income from your pension (over and above the tax-free lump sum), this will increase your tax bill and may limit your options for paying into your pension in the future.
Similarly, when you retire, you can leave your pension untouched if you wish. Pensions are highly tax-efficient and are outside your estate for Inheritance Tax purposes. If you have other sources of income and capital, it can be more effective to use them first.
Defined Benefit Pensions
You can still take a lump sum if you have a defined benefit pension. This type of pension does not build up a ‘pot’ as such, but provides you with an annual income for life. Most scheme pensions also include spouse’s benefits and index-linking.
Some defined benefit pensions include a lump sum as standard, for example, three times your annual income. Whether or not there is a lump sum included in your benefits, you should also have the option to reduce your income in exchange for a higher lump sum. This is known as ‘commutation.’
A higher lump sum offers you more flexibility, particularly if you are likely to spend more in the earlier years of retirement. It can also be useful if you want to leave a pot of money to beneficiaries other than your spouse, or if you have health issues that could impact your life expectancy. However, it will also reduce your annual income, and may result in you receiving less in scheme benefits over the course of your retirement.
Lifetime Allowance Considerations
If you have a large pension pot, your tax-free lump sum may be capped.
The Lifetime Allowance is currently £1,073,100, and will remain at this level until at least 2028. Benefits above this level are taxed at 25% plus your marginal rate of tax if taken as income, or 55% if taken as a lump sum.
This means that if your pension is valued at £1,073,100 or higher, your tax-free lump sum will be limited to £268,275.
There may be exceptions to this if you have transitional protection, or if you have a pre-2006 scheme with a higher lump sum.
What if You Have a Higher Lump Sum?
Depending on your scheme type and work history, you may have a lump sum that is higher than 25%.
There will be conditions around how you take your pension benefits which may not suit your circumstances. You will have the option to move your benefits to another provider, but you risk losing your enhanced benefits.
It’s a good idea to seek advice if you have a higher lump sum to make sure you make the most of your benefits.
Options for Your Lump Sum
When it’s time to take your pension benefits, you should consider your goals and your circumstances.
If you have an immediate use for the money, it makes sense to take your lump sum in one go.
You could also use your lump sum to top up your emergency cash reserve. It’s a good idea to set aside at least 6 months’ expenditure, plus any short-term spending requirements in an easily accessible cash account.
You can take your lump sum and invest it elsewhere, for example, in an ISA. However, this will bring the money back into your estate, which could increase your IHT liability. As pensions are flexible and tax-efficient, it may be worth keeping the money inside the pension wrapper until you need it.
Another option is to withdraw your lump sum gradually, either on its own or combined with income. You can take ‘slices’ of your pension pot in the form of Uncrystallised Pension Fund Lump Sums (UPFLS). Each slice is made up of 25% tax-free lump sum and 75% taxable income. This allows you to make use of your personal tax-free allowance.
If you defer your lump sum, or opt to take it gradually, it will grow alongside your pension pot. You could end up with a higher overall lump sum if you wait a few years or phase the withdrawal.
A financial adviser can help you to make the most of your lump sum, balancing flexibility, tax-efficiency, and your goals for retirement.
Please don’t hesitate to contact a member of the team if you would like to find out more about your retirement options.
