Should you take a tax-free lump sum from your pension?

It's impossible to estimate how many conservatories, new cars and cruises have been bought with the tax-free cash investors can draw from their pension.

Most pension investors have, until now, considered this money - formally known as the pension commencement lump sum or PCLS - as an excuse to go shopping.

Laith Khalaf, pensions expert with independent financial adviser Hargreaves Lansdown, says: "Many people will mentally 'bank' their tax-free cash for a specific purpose - a round-the-world cruise or paying off the mortgage, for instance. There is nothing wrong with that, but you just need to make sure you hit retirement with enough savings to be able to use the tax-free cash for this purpose."

Low annuity rates, inadequate savings, increased longevity and now the threat that the government may drop the triple-lock guarantee (the promise that state pensions will increase each year by the lowest of inflation, earnings or 2.5%) after the next election, are forcing investors to reassess how they use their tax-free cash.

It's become vital to make the most of every part of your private pension savings, according to Chris Noon, partner at Hymans Robertson. "I think people will now use the tax-free cash to optimise their income. Fewer people will be able to take their cash and spend it: they won't be able to afford losing the income it could have generated."

The PCLS is cash you can withdraw from your pension fund any time from the age of 55. Provided you have not exceeded the pension lifetime allowance (currently £1.5 million, but due to drop to £1.25 million for the 2014/15 tax year) you can take up to 25% of the value of your fund free of tax, whether you have invested in a defined contribution (or money purchase scheme), or a defined benefit (final salary or career average scheme).

However, deciding whether to take the cash is not as straightforward as it sounds. The benefit varies considerably depending on what type of scheme you are invested in, and other factors such as the size of your fund and your state of health will also influence your final decision.

Always take advice

As with all issues to do with pensions, it is wise to seek independent financial advice when considering whether to take tax-free cash and what to do with it.

Taking your tax-free cash from a money purchase pension scheme is a fairly straightforward decision, even if you want to maximise the income you can generate from your savings. Noon says: "Provided you use tax-efficient wrappers like ISAs, it can continue growing and generating an income tax-free. But if instead you used this money to buy an annuity, the resulting income would be assessable for tax."

The income you generate by investing your tax-free lump sum might not be as high as that produced by an annuity. A £100,000 pension fund would buy a 65-year-old a level-term annuity of £5,800 a year, according to Hargreaves Lansdown. But the income generated by a £75,000 annuity combined with a £25,000 investment in an equity income multi-manager fund yielding 3.95% would produce a total of about £5,350.

There are still advantages to this route, says Khalaf: the investor has access to the £25,000, and there is potential for the investment and the income it generates to grow.

But he warns that such funds can fall in value too, adding: "An annuity gives you certainty and is paid for life, which shouldn't be underestimated."

Deciding whether to take tax-free cash from a defined benefit pension is much more complicated, as the impact on retirement income is potentially much greater.

Different pension schemes use different "commutation factors", the figures used to work out how much pension income you have to give up for a certain amount of tax-free cash. But Khalaf estimates that for a defined benefit scheme where the saver has a £10,000 annual income (before taking tax-free cash), the amount they could withdraw as cash would typically be £46,000, leaving them with a residual income of £6,900 a year.

"The important thing to bear in mind here is that the income from the final salary scheme is increased in line with inflation each year. This is a valuable benefit that needs to be considered," he says.

Many modern defined contribution schemes have been designed to enable you to take your pension in stages through income drawdown - where you leave the money invested and withdraw an income rather than buying an annuity.

This means you can "crystalise" or convert as much or as little as you like into tax-free cash and income drawdown as suits you at the time. If you are planning a phased retirement, gradually decreasing the amount you work, this offers considerable tax advantages, both during your lifetime and after.

Robert Graves, head of pension technical services at pension provider Rowanmoor Group, points out that if you are earning a salary and don't need to draw an income straightaway, you can still take tax-free cash by crystalising part of your fund without drawing an income.

"So if you would like £10,000 in tax-free cash, you could crystalise £40,000 into pension benefits, enabling you to take one quarter as cash and leaving the rest untouched but available to draw income from when you are ready," he explains.

This gradual conversion of a pension fund also helps the investor to reduce potential death duties on his or her pension fund. Hopkinson says: "If you take all your tax-free cash in one go, your estate could face a 55% tax bill on the remaining money if you die.

"However, if you have a pension that enables you to take tax-free cash from a portion at a time, it means you will only pay the 55% tax bill on that portion, not the whole of your pension fund. The remainder can be passed on to any beneficiary completely free of tax."

Deferring your state pension

You can build up a lump sum of cash by deferring your state pension for at least one year. The lump sum comprises the deferred payment plus interest at 2% above base rate, compounded.

Taking this cash cannot push you into a higher tax bracket, regardless of the amount, and once you've taken it, you will get the standard pension as normal.

Alternatively, you could choose to have a bigger weekly pension rather than a lump sum. For every five weeks you delay claiming, your future weekly allowance is increased by 1%. So after one year, you will get the full pension plus 10.4% extra, but this is not compounded.

Deferring could work well for those who plan to work on after state retirement age, but Khalaf says the benefits may be less generous for those who reach this age after 2016.

"Deferring state pension to get a lump sum is a reasonable, if not outstanding, deal, and it's probably a better deal to defer your state pension to get a higher income. However, the government is planning changes to the state pension and the terms of deferral are likely to become less generous from 2016 onwards. Indeed, the ability to defer and take a lump sum is planned to be abolished," he says.

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