When most people talk about “Pension Lump Sums” they are referring to special rules which allow the withdrawal of a lump sum from a pension pot without paying income tax. This special type of lump sum is called a “Pension Commencement Lump Sum” (PCLS), usually applies to 25% of your pension pot and there are very generous tax rules that can be taken advantage of, if applied correctly.
The government encourages everyone to save into a pension with tax relief – when you pay into a pension you get your income tax added back into your pension pot. However, when you come to draw your money out of your pension you are then taxed on as if it were regular income. The exception is the 25% tax free lump sum, a lump sum that can be withdrawn from your pension pot free of income tax. There is flexibility about how and when you can take it; it doesn’t have to be all at once, or at the start of your retirement.
There are different rules depending on whether you have a Defined Contribution or Defined Benefit Pension (often referred to as Final Salary), with the Defined Benefit (DB) schemes being more straightforward but with the Defined Contribution (DC) schemes tending to have more flexibility in what can be done and when with a tax free lump sum.
When and how you take your 25% tax free lump sum can effect how the rest of your pension pot is treated and taxed, so you need to take into account the whole picture before making any withdrawals. This article should help with a background understanding of tax free lump sums but do be aware that there is a lot more to the subject and how tax free lump sums operate. Please do get in touch with a professional if you are uncertain or think you would benefit from some advice.
There are 2 versions of pension pots, either Defined Contribution or Defined Benefit (aka Final Salary). Although it is common to have both, or a number of each.
Most of this article relates to those with DC pensions (which is the vast majority of pensions today) as there is much more flexibility with DC pensions, more can be done and so more to write about. Those with DB/Final Salary pensions are still eligible for a tax free pension lump sum, although there are different rules to take into account. Please jump to the section on Pension Lump Sums for Final Salary Pensions to find out more.
Any income you receive from your pension is taxable at your marginal rate of income tax. So while you won’t pay any tax on your 25% lump sum there will be tax to pay on the remaining 75%.
When you withdraw your 25% tax free lump sum from your pension pot you will need to decide what to do with the other 75% of your funds, as these will be eligible for income tax. Income received from your pension is usually taxed at your marginal rate on income tax, so if you have income from a job or pension you will likely pay some tax as these funds will be added onto your earnings. So for example if you currently earn £60,000 a year, and are in the 40% tax bracket, then any taxable pension income will be taxed at 40% (until you eventually hit higher tax bands). In this example it is only 75% of the lump sum you withdraw that will incur the 40% tax, the other 25% will be tax free. So if you withdraw £10,000 then £2,500 would incur no tax with the remainder (in this example) paying 40% (for a tax bill of £3,000).
However, you do not need to access the 75% at the same time as the 25% tax free lump sum. The remaining 75% can be placed into a “drawdown fund” (also called a crystallised pension pot) where it can continue to be invested until you decide to access it. It is at the point in which you access the “drawdown fund” and take cash out that you are taxed. The 75% can also be used to purchase an annuity, and so there will be no income tax to be paid on the fund when they are drawn down (although the annuity income will be taxed as you receive it over the coming years).
Yes, you can continue to work whilst also withdrawing money from a pension. This can be useful if you need a quick cash boost to immediately pay off a mortgage, clear debts, or make a significant purchase etc.
You can even continue to pay into a pension after you have begun to withdraw. However there are strict rules around how much you can take out and if these rules are breached then a limit will be applied to how much you can contribute into your pension pot each year. Called the Money Purchase Annual Allowance (MPAA) it currently limits those who have accessed their pension pots in a flexible manner to £4,000 per annum. The rules on what triggers the MPAA are complicated but broadly taking out anything apart from your 25% lump sum or buying a fixed annuity will trigger the MPAA. It is highly recommended to get advice from a pensions expert if you think you are at risk of triggering the MPAA, as it is irreversible and can have a significant negative impact on your retirement planning.
Withdrawing funds early from your pension pot early reduces the amount of time it has to grow and so reduces the amount of pension available at a later time. If you decide to reinvest part or all the lump sum you withdraw then these investments will no longer benefit from the tax free growth that pension pots benefit from.
Receiving pension income (above the tax free lump sum) while you are still working is likely to incur a higher income tax charge as it will be calculated in addition to your current earnings. Successful retirement planning involves making sure that funds are invested and moved around in the most tax efficient way and take advantage of all of the tax breaks available.
Your pension lump sum is yours to do with as you please. It is money you have worked hard to earn over your lifetime and there are no rules restricting how you may spend it. But please be aware that it is very common to underestimate how long you will spend in retirement and how much you need to set aside to have the comfortable retirement that you want. Taking a tax free lump sum reduces your pension pot and as the money is no longer invested you may find your pot depleted by much more than you took out.
In short, please take careful consideration when withdrawing a lump sum as there are other consequences.
You don’t have to take a PCLS if you want to. You may want to turn all of your pension pot into an annuity for example, and so do not want to take any it as a lump sum, even if it is tax free. Or you may decide you want to leave your funds invested in your pension to pass on to your family outside of your estate (one of the benefits of a Defined Contribution Pension is also the ability to avoid inheritance tax on your pension assets).
Is now the best time to take a lump sum? Whilst it might seem like an easy decision to take your tax free lump sum as soon as you can and as much as you can, there are some dangers around taking funds out of your pension at the wrong time that you need to consider.
Most defined contribution pensions will allow you to withdraw your tax free lump sum at any point from becoming eligible, meaning you potentially have decades to take your lump sum and it does not need to be all taken at once. There may be a more tax efficient time to access it and it will also lose the “tax free wrapper” status that the funds benefited from being in a pension wrapper.
There is always talk about reform of the pension rules, usually around the time of the UK Budget or when there is the need to raise more in taxes. Pensions are often seen as a way of raising extra funds, with the reduction of tax relief for higher earners or a reduction in the tax free lump sum being 2 common suggestions.
Changes to pension rules can have a big impact on those saving for retirement; pension pots are often the largest asset people have (next to their home) and any changes to how it is taxed can have a big impact. Whilst we can never predict the future with total accuracy, we can endeavour to make sure we have planned well enough so that we can meet any change to the rules in the best way possible. A good Independent Pension Adviser should be able to explain more on what you can do to protect your pension from future changes.
Currently from the age of 55 you are able to access the funds in a Defined Contribution pension pot (including the 25% tax free lump sum). For Defined Benefit pensions the scheme rules should be checked.
The age is currently due to rise to 57 by 2028 in line with the rise in State Pension Age.
It is possible that your pension (especially if it is a Defined Benefit pension) may have different rules, and this should be confirmed with the pension administrator before any action is taken.
A choice between a greater lump sum up front or a higher ongoing payment is one that many will face when they start to think about accessing their pension pots, whether defined contribution or defined benefit.
With a defined benefit pension scheme there is often a choice at the point at which your pension begins in which you can elect to exchange part of your ongoing pension payment to an immediate lump sum payment. This is called “commutation” and may be in addition to a lump sum which you are already eligible for. Commutation will usually involve a rate of exchange (e.g. give up £100 of annual pension income in exchange for £2,500 lump sum) but this rate (and if there is any underlying lump sum due as well) will depend on the rules of the individual pension scheme.
Defined contribution pensions have more flexibility than defined benefit schemes and the choice between using your pension pot to either provide a lump sum or a regular payment is one which can be made at almost any point from when you decide to start accessing your pension.
There is no simple answer as to what the best solution is, as everyone’s situation is different. It will not only depend on the cost of taking a lump sum compared to a regular payment (such as the commutation rate) but also on the individuals situation; such as their retirement objectives, other sources of income or financial commitments. Having a well developed retirement plan should make these decisions a lot easier as you will able to better under stand the implications and benefits of taking a lump sum or regular payment.
Tax Free Pension Lump Sums for Final Salary Pensions work in a slightly different way than with Defined Contribution. Each individual scheme has it’s own rules and some (legally) even allow for an amount greater than 25% to be taken tax free. Please contact your pension administrator for the complete picture for your particular scheme.
With a Final Salary pension you will be provided with a pension income when you retire. In addition your pension may also pay out a tax free lump sum (e.g. “2/80ths of final pensionable or career average earnings for each year of pension scheme membership”). Other pension schemes may offer you the choice of taking a tax-free cash lump sum when you retire in return for receiving a reduced pension. This is called “commutation” and each scheme will have it’s own rules on how this is worked out, including a maximum lump sum amount and the “commutation factor”. For example a scheme with a commutation factor of 15 would mean if you took a tax free lump sum of £15,000 then you would have your annual pension income reduced by £1,000 (£15,000\15 = £1,000).
Deciding if it’s worth taking a commutated lump sum depends not only on the schemes rules (how much lump sum you’d get in return for how much pension you give up) but also on your current situation, other financial arrangement, commitments and your plans (are you going to keep working, buy a house, retire etc).
One of the reasons for transferring a Final Salary pension to a Defined Contribution one is to gain access to the flexibility that one has with a DC pension. However, great care (and financial advice) is needed if considering a switch like this, as the benefit of greater flexibility is often outweighed by the income guarantees and protections that a Final Salary Pension has.
Unless you are transferring a pension* from one arrangement to another, it is unlikely that you will be legally required to receive financial advice to access a tax free lump sum. Financial advice generally becomes more beneficial the bigger the pot size, the bigger the importance and the bigger the complexity. With pensions being the biggest asset (aside from their home) for most people and with the financial consequences of making mistakes having the potential to be very expensive then it is often worth investigating if financial advice would be beneficial and worth paying for.
Pensions Flexibilities, which were introduced in 2015, have given us a lot more flexibility and freedoms with what we can do with our pension savings. This means that there are many potential opportunities to boost performance, lower tax payments and help improve your retirement, but unfortunately it also makes it more complex. For example, many are now opting to enter Drawdown when they reach retirement age, which allows you flexible access to some of your pension money while the rest stays invested. This provides a challenge for many savers as they seek to navigate the complexity of both investing their pension correctly and making withdrawals in a sensible, tax-efficient way.
You might have to pay for financial advice, but it can save you money in the long term. The biggest risk that many do not realise they are facing is the risk on missing out on savings or growth that they were not aware were possible. This is alongside the potentially severe tax implications of taking a large amount of money in a given month
If you are unsure about how financial advice may benefit you then getting in touch with a reputable financial adviser for a no obligation chat would be advisable as they should be able to articulate the pros and cons for you particular situation. It is after all hard to make a decision if you don’t fully understand what the benefits and costs are! It may be the case that a quick chat with an IFA is all you need in terms of financial advice.
*If you are transferring a defined benefit pension which is worth more than £30,000 to a defined contribution pension, you are legally required to use a financial adviser. The Financial Conduct Authority introduced this requirement to serve as safeguard to help prevent people making the wrong decisions in what is a complex and risky area. By doing so, it is the adviser who takes on the risk and liability of the pension transfer.