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The Solution to Pension Tax Free Lump Sums

Richard Beardsworth Pension Expert

By Richard Beardsworth.

Independent Financial Advisor

More Reading on Pension Drawdown...

Making wise decisions does require understanding the rules and taking advantage of all the guidance and advice one can find. However, in the end, the solution to the question of what you should do with lump sum payments comes down to mathematical equations. You can figure out what the best options are simply by running the numbers in relation to what it is you are trying to accomplish.

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At the risk of being overly simplistic, we will present you with two different scenarios to illustrate the point of using maths to figure out the best course of action. These are only examples. You should definitely seek out government guidance and qualified advice from a certified financial advisor before charting your own course of action.

Taking All at Once

In our first scenario, a 58-year-old pensioner named John decides to take an entire pot as a single, lump sum payment. This pot is part of a workplace pension he has been contributing to for the last 20 years. He also has two smaller pots from previous employers that he plans to leave intact for now. Let us do the maths to understand how this would work out.

John will take his entire £75,000 pension during the 2015 tax year. He will also continue working his £50,000 per year job; his two smaller pension pots will be left alone until he retires. Where his lump sum payment is concerned, he will not be paying taxes on the entire amount. The tax on pension lump sum payments does not apply to the first 25%, giving John £18,750 tax-free. The remaining £56,250 is then added to his annual salary for a total income of £106,250 for the 2015 tax year.

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John's personal allowance will be £10,500, reducing his taxable income to £95,750. His total income tax for 2015 would be in the neighbourhood of £32,000, leaving him with a net of just over £82,000 when he combines the tax-free lump sum and what is left of the rest after taxes. It is a significant amount of money, but is it worth it based on John's circumstances? Only he can decide. Doing the maths hopefully makes that decision easier.

Taking a Drawdown Contract

Calculating the numbers on a drawdown contract can be complicated. The first thing to understand is that the pension tax-free lump sum is applied differently, based on how a drawdown is structured. There are two primary options, the first being the choice of taking the entire 25% tax-free sum upfront, then gradually drawing down the remaining 75%.

Under this scenario, the tax-free portion of the pension is yours to do with as you please. Your subsequent drawdown payments are then reported with your annual income for tax purposes. We will illustrate this with the example of Jane, who decides to take a flexible drawdown option in order to supplement her £5,881 annual state pension. During the 2015 tax year, her flexible drawdown payments total £20,000.

As with John, she will be able to take advantage of the £10,500 personal allowance for her income taxes. Her remaining taxable income would work out to £15,381 taxed at 20%, for a total tax bill of £3,076.20. Jane will easily be able to meet her expenses during that first year because she will be combining her tax-free lump sum with her state pension and drawdown payments. Next year though, she may have to increase the monthly payment to make ends meet.

The second option with a drawdown contract is to not take an initial lump sum equal to 25% of the pot. Rather, smaller monthly payments will be taken as supplemental income. In that case, only 75% of the monthly payments are considered taxable income; the remaining 25% is tax-free. Doing the maths under this scenario is a bit more complex. However, it may be a better option for savers who find themselves at the upper edge of their tax band, as taking smaller payments could prevent them from being pushed into the higher band.

Your Budget and Goals

As you can see, there is a lot to consider with lump sum payments just where taxes are concerned. Nonetheless, there is more to it than just your income tax. Savers also need to consider their financial goals as well as their monthly and annual budgets. All of this plays into whether or not taking the lump sum is a wise idea.

The complexities involved clearly illustrate why we constantly advise savers to work with a certified financial advisor when making pension plans. You can do the maths yourself when the numbers are pretty basic, but things can get complicated very quickly. For example, let us say you are thinking about taking a final salary pension lump sum. The rules surrounding the pension scheme might be much too complex for you to figure out.

In case you are not aware, the final salary pension scheme is one that pays out based on what you are earning at the time of your retirement. It is typically calculated by multiplying 1/60 of your final salary by the total number of years you contributed to the scheme.

The problem with final salary pensions is that the rules vary so much from one scheme to the next. Your scheme may be set up in such a way as to make lump sum payments too expensive to take. On the other hand, your scheme might have a very liberal set of rules that make a lump sum payment very attractive. There is really no way to know without figuring out what the rules are and consulting with a financial advisor.

Two Things to Consider

As you work with a financial advisor to apply the maths to your circumstances, there are two additional things to consider. The first is the fact that any tax-free lump sum you take reduces the total amount of money in your pension pot. Therefore, unless you are taking your entire pot in one sum, what is left over will have less earning potential. If you were earning 5% on £100,000 before, you will only be earning 5% on £75,000 after taking your 25% tax-free lump sum. That could result in a significant difference in terms of what you eventually earn.

The last thing to consider is how much money you will have to retire on if you take a lump sum payment while you are still working. Some people are taking lump sums for the purposes of investing the money in buy-to-let property or another attractive investment vehicle. Some are doing it in order to spend the money on other things. However, just as you are reducing your earning power with every withdrawal, you are also potentially reducing the amount of money you have at retirement. Be careful about the investments you choose if you are electing to use a lump sum payment to fund other investments. You could do very well indeed. Nevertheless, you could also lose substantially.

Taking a pension tax-free lump sum payment is one way to take advantage of all the opportunities made available through pension reform. On the one hand, the tax implications are now a lot more agreeable to the average pension saver. On the other hand, taking a lump sum without proper planning is an easy way to get yourself in trouble. The best way to mitigate the risks is to take your time, take advantage of free government guidance, and avail yourself of the services of a certified financial advisor. You can get a list of certified advisors from the FCA website.

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