Should I take the maximum tax-free cash from my pension?

5 July 2013

Q

An independent financial adviser (IFA) who did not have details of my pension told me it is always best to take the maximum lump sum possible from your pension. I have a BT Option C pension. If I were to take £53,000 as a lump sum, I would lose £3,300 a year.Could I buy an annuity equivalent to that with £53,000? If not, would it not be better for me to have the higher pension? I also make additional voluntary contributions (AVCs) each month into my work pension.Is this generally a good idea?
From
JR, Somerset

A

There is a common misconception that it is best to take the maximum tax-free lump sum from a pension, but this isn't always the case.

It can be beneficial to do this with a personal pension because even if you just want an income you can use the lump sum to buy a purchased life annuity (PLA). You can buy this with any available cash and it has tax benefits over a compulsory purchase annuity (CPA), which a pension scheme would buy.

The income from a CPA is all potentially taxable, while some of the income from a PLA isn't taxable, as it's deemed to be a return of your capital rather than income. However, annuity rates for CPAs can sometimes be better than for PLAs. But the situation becomes far more complicated with a defined benefit pension scheme, such as your BT Section C scheme.

Find the best annuity rate for you circumstances

What you should do will depend upon your situation, objectives, other sources of retirement income, pension scheme benefits and how much income you give up to take a tax-free lump sum.

Very often when you release a lump sum from a Defined Benefit pension, you give up additional pension benefits to facilitate this. For example, by taking a 25% lump sum, it could end up costing a reduction of 30% to 40% in the pension.

As you are also making AVCs, you may be able to take the main scheme lump sum from the AVC scheme. Look into this, as you would receive the lump sum without seeing a reduction in your inflation-linked main pension income.

Your health is also an important factor, as if you're in poor health you would be better taking the lump sum. However, if the value of the lump sum when added to the rest of your estate could potentially create or increase an inheritance tax liability on your death, this might favour taking the higher income.

Your tax position also becomes an issue, as pension income is taxable, so you will get less net income from the scheme if you're a higher-rate taxpayer as opposed to a basic-rate or non taxpayer. In this situation, the tax-free lump sum might seem preferable to a higher-rate taxpayer than it would to a basic-rate income tax or non-taxpayer.

Taking the lump sum may also be preferable if you have a sizeable expenditure to fund. You should speak to an IFA, who will investigate your case thoroughly before making any recommendations.

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