Many older savers - whether they are still working or recently retired - might be looking at their pension pots in a new light amid this year’s cost of living shock. For instance, those who had never considered taking the 25% lump sum before they retire could be more tempted to do so, especially if they have debts that are now looking tougher to clear or non-dependent children who are struggling financially.
The obvious drawback is that it takes a big chunk out of one’s pension savings at the start of retirement, or even before, and the diminished pot is then likely to provide a leaner income over the remaining retired life. Together with the fact that many pension funds have done poorly this year, meaning that taking a big lump sum now will probably mean crystallising losses on investments rather than letting them recover, could inflict a double whammy on one’s personal wealth.
Smith highlights the fact that the tax-free lump sum does not need to be taken in one go, and that 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 best option available to them,’ says Smith. ‘For those who don’t have such debts to pay, drawing lump sums in flexible amounts could be more beneficial for a number of reasons.’
Smith picks out three:
- Reduced values. Given recent investment performance, the values of pensions might have fallen and, if the retiree takes the full 25% 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 the coming years, then they will have access to more tax-free cash.
- Generating a tax-efficient income. 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 uncrystallised fund lump sum payment, where 25% 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 should 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.
- Holistic estate planning. 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 those funds might become subject to 40% inheritance tax. Therefore, only accessing the lump sum when it is required can be beneficial for IHT purposes.
However, there are circumstances where the saver has less choice in the question of how to access their lump sum.
Tax-free cash in excess of 25%: Under occupational pension rules some schemes offer over 25% of tax-free cash. In order to take a ‘protected’ lump sum it has to be taken at once. If you only wanted to take a phased amount the protection would be lost and the tax free cash would reduce to 25%. So, let’s say someone has a pension fund of £200,000 and the ‘protected’ tax-free cash amount is £100,000. In order to take this lump sum it would have to be taken in one-go and the remaining £100,000 would go into drawdown. However, if they only wanted to take a sum of £25,000, then the tax-free cash on the whole pension would reduce to £50,000 (25% of the £200k value), resulting in a loss of £50k tax-free cash. Therefore, where there is a ‘protected’ sum, taking a one-off sum is often the only option available.
Defined benefit pensions: For those with defined benefit pensions, 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.
Smith concludes: ‘The question of whether to take the 25% tax-free cash from a pot all at once or in instalments is a very individual decision, with no one-size-fits-all answer. But many savers are not, or only vaguely, aware of the option to stagger withdrawals and its benefits, so there might be a bit of a knowledge gap to fill.’
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