Should you take a 25% pension lump sum upfront or in chunks?

Taking a tax-free sum from your pension pot is a popular perk at retirement, but it might be worth adopting delaying tactics in current volatile markets. You can still get 25 percent of your pot tax-free if you opt to withdraw it gradually in chunks.

This strategy gives you the chance to avoid locking in recent financial market losses, wait for your investments to recover, and if your pot grows again have more tax-free cash available to take in the longer run.

Retirement planning: Savers with investments in defined contributon pensions are not limited to just one chance to take a 25% tax-free lump sum

Retirement planning: Savers with investments in defined contribution pensions are not limited to just one chance to take a 25% tax-free lump sum

Recent data from DIY platform Interactive Investor revealed pension investors are trying to protect their retirement pots from turbulent markets by taking far smaller tax-free lump sums and at a later age.

This suggests there might be a move away from full upfront lump sums to taking them in chunks, but the figures aren’t conclusive.

II’s analysis also showed income withdrawals to fund everyday spending have risen, suggesting efforts to preserve capital are being frustrated as the increased cost of living squeezes people’s budgets.

Becky O’Connor, head of pensions and savings at II, says recent behavioral trends might be temporary while times are hard – for however long that may be – amid nervousness about making a pension pot last, and the need for higher income to cope with regular bills.

‘You think of what £100,000 sounds like when you can expect 5 percent growth a year from your pot and inflation is running at 2 percent and you think “OK, there’s a chance I can make this last”.

‘And then you think about it right now, when you might well get negative returns and you can’t afford your energy bills without taking more out, and that £100,000 suddenly doesn’t sound like an amount you can rely on.’

What are your 25% tax-free lump sum options?

Savers with investments in defined contribution pensions are not limited to just one chance to take a tax-free lump sum worth 25 percent of their pots – instead, they can benefit from untaxed chunks over multiple withdrawals.

However, you lose the tax-free perk if you tie up your entire pot in an annuity or income drawdown scheme.

Your rental income can also affect your pension.

You, therefore, need to ensure that the bulk of your pension cash remains in an ‘uncrystallized’ arrangement, with either your current pension provider or anywhere else that you transfer it.

What are defined contribution and final salary pensions?

Defined contribution pensions take contributions from both employer and employee and invest them to provide a pot of money at retirement.

Unless you work in the public sector, they have now mostly replaced more generous gold-plated defined benefit – or final salary – pensions, which provide a guaranteed income after retirement until you die.

Defined contribution pensions are stingier and savers bear the investment risk, rather than employers.

Assuming you do not take your 25 percent tax-free lump sum upfront, each chunk you take from the uncrystallized pot will be 25 percent tax-free, reflecting the 25 percent tax-free cash that is available on all pension funds, and 75 percent taxed at your marginal rate.

The marginal rate is whatever tax band you are pushed into once all income, including withdrawals from your pension, has been counted.

As with working-age people, those above retirement ages have a personal allowance, which is the amount of income allowed before tax is payable – it is currently £12,570.

On anything above that, you are taxed at 20 percent, 40 percent, or 45 percent, depending on the size of your income.

The rules on tax-free lump sums differ for final salary pensions – see below.

‘Tax-free cash is one of the main benefits of pension saving, with most pension savers being able to take 25 percent of their pension value as a lump sum,’ says Gary Smith, financial planning director at Evelyn Partners.

‘However, although this is a lump sum payment, a retiree does not need to take all of their lump sums in one go and it is possible to take multiple payments at different times.

‘For those who have interest-only mortgages, or debt to repay, taking a one-off lump sum to settle these debts might be the only option available to them. For those who don’t have such debts to pay, drawing lump sums in flexible amounts could be more beneficial.’

Your 25% tax-free lump sum: What to consider

1. Do you need the cash

Your personal circumstances might be the deciding factor if you have debts or a cherished spending goal in mind for a lump sum.

‘The ability to draw out a one-off, large tax-free lump sum on retirement can be really beneficial,’ says Ray Black, managing director of chartered financial planning firm Money Minder.

‘This is especially true for those retirees who have an outstanding mortgage or personal loan balance to pay off.

‘Some newly retired individuals may want to spend a large amount of capital on a new car, a caravan or camper van, a special retirement holiday or home improvements.’

2. Market performance

People with defined contribution pensions can continue to benefit from tax-free investment growth on the portion of their pot they have not yet withdrawn.

And when markets have fallen, it gives your pot a chance to recover and grow again if you take the 25 percent tax-free part of your pension bit by bit.

O’Connor says: ‘Usually, when people start to access their pension for the first time, they wait until they stop or wind down from work, then take some or all of their tax-free lump sum and then move into taking taxable drawdown income with the rest of the pot.’

But she says II’s recent data suggests people are showing more caution about taking too much out too early and might want to delay big retirement decisions.

‘A “wait and see” approach when stock markets are volatile and prices are rising is understandable.

‘It might seem prudent to leave as much of that lump sum as untouched as possible in order to wait for markets to recover – potentially allowing you to take more tax-free income later on.’

Smith says: ‘Given recent investment performance, the values of pensions might have fallen and, if the retiree takes the full 25 per cent lump sum now, they might effectively be “locking in” the reduced value.

‘Alternatively, if they only take part of their lump sum, and the values of their pensions subsequently recover in value in the coming years, then the value of the remaining tax-free cash they can take could be higher.’

3. Tax efficiency

Combining some of your tax-free cash with a taxable income payable as a drawdown pension is often referred to as ‘phased retirement’, says Black.

‘The main advantage to phased retirement is that each payment can be a mixture of both income and tax-free cash and allows the retiree to be in more control of their income tax liability each year.

‘However, other advantages include the ability to start a regular taxable income in conjunction with a tax-free cash payment on a regular basis.

‘For example, £750 per month income payment plus £250 per month tax-free cash payment, with the potential ability to take a one-off tax-free lump sum to pay for holidays and so on as and when needed.

‘Please remember, this is only an option when there is extra tax-free cash available. The pension provider will keep records of how much tax free cash has been withdrawn over the years, but once it’s gone, it’s gone.’

Black says phased retirement helps to ensure that you are in control of what you take and when you take it, enables you to plan your income around your personal income tax situation, and potentially allows you to enjoy a high level of income without a large income tax liability.

Smith says: ‘When someone retires, they might not have any other taxable income until they qualify for their state pension.

‘During this period, the retiree might opt to take £16,666, via an uncrystallized fund lump sum payment, where 25 percent of the payment (£4,166) is paid tax-free, with the remaining £12,500 taxable income.

‘However, as this income would fall within the retirees’ unused personal allowance, they might be able to reclaim any income tax deducted, enabling the full amount to be drawn tax-free.

‘They could then repeat this exercise during subsequent tax years until the state pension commences.’

4. More than 25% tax free cash

You should check the rules on all your old pension schemes because you might be allowed to have more than 25 percent tax-free.

‘On some old style pension arrangements it is possible to have “protected” lump sum benefits that exceed 25 percent of value,’ says Smith.

‘Under these types of policies, the retiree will typically have to take a lump sum in one go as, if they took it in phased amounts, then the protection would be lost with only 25 percent of value available.’

5. Final salary pensions

Savers with final salary, also known as defined benefits, and pensions are in a different situation.

Smith says: ‘The only option the retiree will have is whether or not to take no tax-free cash, the standard tax-free cash or the maximum tax-free cash, and this decision must be taken at retirement.’

Also, the tax-free lump sum offers made by final salary schemes when members begin retirement can vary widely and you need to take this into account.

How it works is that you are allowed to take anything up to 25 percent tax-free. But the bigger the lump sum you withdraw, the more future pension you sacrifice – and some schemes force you to forfeit more than others.

What you give up is down to the ‘commutation factor’. For example, you might be offered £12 in the form of a lump sum for every one pound of future pension you give up. This is a commutation factor of 12:1.

But some schemes will offer you a £20 lump sum for every pound of pension income you sacrifice. That would be a far more favourable commutation factor of 20:1.

This is Money columnist Steve Webb explains what to consider when taking a tax-free lump sum from a final salary pension here, and how some lump sum offers are more generous than others here.

6. Taking anything beyond your 25% tax-free cash

When you start tapping a defined contribution pension pot for any amount over and above your 25 percent tax-free lump sum, you are only able to put away £4,000 a year and still automatically qualify for valuable tax relief from then onward.

This new and permanent limit is known in industry jargon as the ‘money purchase annual allowance.

7. Inheritance planning

Taking tax-free sums in chunks, or ‘phased retirement’, can be helpful if you want to use your personal tax allowance each year whilst also enjoying a tax-free income from investment Isas, says Black.

‘This method of income planning can enable an individual to target assets that would potentially be liable to inheritance tax, for example, investment Isas and cash savings, and leave funds that, under current rules, in the majority of cases won’t form part of their estate for inheritance tax calculations on death.

‘On death, money left inside a drawdown pension plan can normally be used to provide a pension for your surviving spouse and or dependents.

‘Depending on the individual rules of the pension plan, the money may also be able to be paid out as a tax-free lump sum.

‘Under the current rules, if you are under the age of 75 at the date of death, not only will the value of the pension fund not form part of your estate for inheritance tax purposes, but it may also be possible for the people who inherit your pension plan to leave the fund invested and ‘draw down an income from it for the rest of their own life without having to pay income tax on what is paid out to them.’

Black says this is a very generous and tax-efficient planning tool that could benefit children, grandchildren, and beyond.

Smith says: ‘Pension funds, under current legislation, remain outside of your estate for inheritance tax purposes and this might be important if the individual’s estate already exceeds their available inheritance tax allowances.

‘If the individual were to withdraw their full tax-free cash, and simply deposit it or invest in another savings vehicle, then this lump sum might become subject to 40 percent inheritance tax.

‘Therefore, only accessing the lump sum when it is required is often beneficial.’

8. Get advice or guidance

O’Connor suggests approaching Pension Wise, the free Government-backed service for over-50s, or speaking to an independent financial adviser.

‘It can be very difficult to work out on your own what is the best way of accessing your pension, especially during difficult economic times.’