It used to be the case that, as you entered retirement, you had to purchase an “annuity” (i.e. a financial product providing a fixed retirement income).
With the introduction in 2015 of ‘Pension Freedoms’, however, this is no longer a requirement. In 2019-20, it is now possible to start taking money from your pension pot once you reach the age of 55.
Moreover, from this point, most people are also allowed to withdraw up to 25% of the value of their pension savings as a tax-free lump sum in cash. You are not obliged to do this, and there are several factors to take into account with your financial adviser before making your decision.
In this article, we’ll be outlining some of those factors and sharing some useful information about the 25% lump sum which might be helpful to you. Please bear in mind that this content is for information and inspiration purposes only. To receive personalised, regulated financial advice we recommend that you consult a professional financial adviser.
Your Lump Sum: An Overview
It’s important to be aware of the crucial rule surround your lump sum. For instance, it’s important to note that if you try and access your pension pot before the age of 55, then you will likely face 55% tax on the amount you withdraw. So be very wary of any business, individual or website which claims it can help you access your pension cash, tax-free, before the age of 55. There are only very limited circumstances where you can access this cash early (e.g. if you have been diagnosed with a terminal illness), and you should consult your financial adviser to ensure that you will not be hit with a hefty tax bill if you think these circumstances might apply to you.
Another important aspect of your tax-free lump sum concerns the type of pension you have. If you have a defined contribution pension, then the process with your adviser is fairly straightforward. Here, it’s a matter of taking your pension pot and taking up to 25% of the total as a tax-free lump sum.
If you have a defined benefit pension, however, then the process is usually more complicated because this type of pension does not build up a “pot” of retirement money over time. Rather, your employer promises to pay you an income in retirement based on factors such as your average earnings over your career, and your years of service. Here, you will need to work out your pension scheme’s “commutation factor”, which establishes how much of your retirement income you will need to give up in exchange for a tax-free lump sum.
One area where you need to be careful concerns “uncrystallised” and “crystallised” pensions, as this can affect the rate of tax on your withdrawals. The former refers to a pension fund which has not been converted into an income (e.g. by opting for income drawdown or buying an annuity). In these circumstances, for instance, you might still be employed in your 50s or 60s but want to “top up” your income by taking various lump sums, ad hoc, out of your pension pot. If you want to do this, it’s important to consult your financial adviser as the paperwork can be quite complex. Each lump sum you withdraw is usually 25% tax-free, whilst the remaining 75% is typically taxed at the rate of Income Tax which you are paying.
The latter (i.e. “crystallised” pensions) refers to when you have formally decided to start taking your retirement benefits, such as in the form of an annuity. This is the point where you might decide to take 25% of your pension pot as a tax-free lump sum (or not).
Is a Lump Sum Withdrawal a Good Idea?
Before you consider taking lump sums from an uncrystallised pension, it’s important to check whether your pension scheme allows you to take uncrystallised pension lump sums (UFPLSs). If not, then your main option for accessing a lump sum from your pension will likely be to consider crystallising your pension with your financial adviser, and taking up to 25% tax-free.
Whether or not you should take your 25% lump sum, however, is an important question and the answer will vary according to your unique financial goals and circumstances. For instance, if one of your main financial goals is to pay off a large debt, or to settle your mortgage early (assuming your lender allows this), then taking your tax-free lump sum could help make this possible. A large lump sum could also be put towards a longed-for home improvement, such as an extension, or spent on a luxury item as a “retirement reward” (e.g. a new car, or holiday cruise).
On the other hand, there are disadvantages to taking your tax-free lump sum, which you should weigh carefully with your adviser. In particular, a 25% withdrawal is likely to significantly reduce the size of your pension pot, which could result in a lower income during retirement. This is because you might not be able to afford a better annuity or to draw down as much from your pension pot. You also need to be aware of how taking your lump sum might affect your annual allowance. Usually, you can contribute up to 100% of your annual salary (or up to £40,000 - whichever is lower) towards your pension each year. Once you start taking your pension benefits, however, there is a strong chance that your annual allowance could be dramatically reduced to £4,000 under the Money Purchase Annual Allowance rules.
As a general principle, when it comes to deciding how to approach your lump sum, it’s a good idea to consider what you would do with this amount if you took it, and what kind of financial position it would leave you in. For instance, if you can still achieve your long-term financial goals in retirement whilst also taking your full 25% lump sum, then you might be able to justify committing this money towards a big spend.