About your Pension Lump Sum

What you can take

When it comes to the time for retirement, the choices open to you with regard to your pension planning are relatively straightforward. You can use your pension pot to create an income, most commonly through the purchase of an annuity. But you are also able to take up to 25% of your accumulated fund as a tax free cash lump sum.

Most retirees opt to take the whole of the cash fund available to them, and in general this is a good strategy. If the money were left within the fund and used to buy an annuity, then the income generated would be treated as taxable income.

The downside, of course, is that by taking the cash lump sum you cut down the amount of income that your pension fund could give. A pension fund of £100,000 will buy you an income in retirement of around £500 per month. Take the full allowance of the 25% cash lump sum out, and the income falls to around £375. That’s a big drop and one that you need to consider carefully before exercising your lump sum rights.

Of course, it might be possible to use your lump sum to create further income which may go some way to closing this income gap.

Should you take the cash lump sum?

It’s tax free, you can use it how you wish, and it’s a big financial boost at an important time of your life. Of course you should take it. But wait: there is an issue that you need to be aware of before making your final decision. If you are considering taking the cash from a defined benefits plan, then the calculation of how much cash is available to you is different than for defined contribution plans. In a defined contribution plan, the accumulated fund is visible. Defined benefits plans work differently. From a defined benefits plan, you receive a given amount of your final salary as an income through your retirement.

Defined benefits plans calculate the cash lump sum by multiplying 25% of your annual pension by 20 (years). However, in order to calculate the income now available to you, the pension administrators will use what is called a commutation factor. The lump sum taken will be divided by the commutation factor, and then the resulting amount deducted from your annual pension.

If your annual pension available is £20,000, then the lump sum available would be £100,000. If the commutation factor is 20, then by taking the lump sum you lose £5,000 of annual pension income. However, if the commutation factor is 10, you would lose £10,000 of annual income.

If you are lucky enough to have a defined benefit pension plan, then give serious consideration to the commutation factor and the effect on your income before taking the cash lump sum. The lower the commutation factor, the greater the impact of taking the cash lump sum on your pension income.

What can you do with you tax free cash?

The money is yours to do with as you wish. But you need to use it wisely: once it’s gone, there is no bringing it back. There are plenty of options that need to be considered:

• Paying off debts, perhaps your mortgage, credit cards, loans, or hire purchase agreements, can massively reduce your outgoings. If you do have debts, it is most likely that the interest you are paying on the borrowed money will be far higher than the amount of income you could generate by investing the lump sum. Debt repayment will reduce your outgoings and give greater financial stability.
• You could invest the lump sum. This could be for income, if you need it now, or for growth for the future. Investing through ISAs will give your cash further tax advantages, though there are maximum annual limits on such investment.
• If you do require income, then perhaps you could consider buying a purchased life annuity. This works in a similar way to the annuity you will buy with your pension fund, except that some of the income will be tax free.
• You could, of course, invest in an investment bond. By doing so, you will have the option to take 5% as ‘income’ each year without paying tax on the withdrawal until maturity, when the tax calculation may be more advantageous.
• Often overlooked, it may be possible to invest in a pension plan for your spouse (though the rules on doing so are constantly changing so advice should be taken in this regard). If this is possible, then you will benefit from the tax advantage that pension scheme payments have a second time on your money.
• Finally, you may decide to treat yourself to that once in a lifetime holiday, or the boat you have always wanted, or a new car. After all, it’s your money, and you’ve worked all your life for it. It’s there to have a little fun with, isn’t it?

In summary

The first decision to make about your tax free cash lump sum is whether you should take it. In general the answer will be to take the full amount possible, but you should consider the effects on continuing income, especially when taking the cash from a defined benefits scheme.

Once you have made the decision to take the cash, further thought needs to be given as to how to use it. The decisions you make now will impact the rest of your life. Paying off any debt is usually a top priority as this will cut your regular expenses, and make budgeting easier.

After this, if you don’t need the extra income you could create, then it may be best to invest for growth for the future. Or perhaps you want to be a little frivolous and spend some. The choice is yours, though you may decide to seek advice to help you make that choice.