The day you retire and transfer your pension fund into an income you’ll get the chance to take up to 25% out in cash, tax free. This can easily equate to tens of thousands of pounds, so is this money a nice retirement bonus or will you lose out?
One of the many decisions you have to make when you come to retire is whether or not to take a tax free lump sum from your pension fund.
Under current rules you can cash in up to 25% of your fund tax free, and with many pension funds reaching six figure sums this can represent a significant amount of cash.
But with annuity rates at an all time low and a modest state pension from the government, does it really make financial sense to withdraw a lump sum, or leave it in your pension fund to get a better income throughout your retirement?
Here’s what you need to consider before deciding whether or not to cash in on your tax free lump sum...
Find out exactly where you stand
The first step you need to take when deciding whether to take a lump sum from your pension fund is to find out exactly what difference it would make to your retirement income.
If you’re going to use your pension fund to purchase an annuity you can ask for an income quote using your total pension fund and your fund minus the lump sum to find out the potential difference.
Doing this will enable you to see exactly how much income you will be sacrificing if you take your lump sum and how long it would take for you to be paid the lump sum through your retirement income should you decide not to take it.
Often simply finding out exactly where you stand can make a big difference to your decision and is essential before looking at other factors.
How much income will you need?
Once you have quotes for the income your fund would generate with and without your lump sum deducted you need to consider the income you will need to live comfortably in retirement.
Include all your regular outgoings and bills together with the estimated cost of any holidays or hobbies you are hoping to enjoy once you stop working – this should give you a rough idea of how much you’ll need to live on.
You may find that the amount of income you need varies depending on whether or not you take you lump sum - especially if you plan to use the money to pay off your mortgage or other outstanding debts.
You may therefore need to draw up two separate budgets with and without your lump sum, so you get an accurate figure when deciding how much money you’ll need.
If you need help drawing up a retirement budget you can use our Action Plan: How to Stick to a Budget or read our guide: How to Write a Budget.
What are the benefits of taking a lump sum?
Although withdrawing a lump sum will mean sacrificing some guaranteed income, there are other financial benefits that you need to consider before making your final decision.
Tax benefits
The major benefit of withdrawing a lump sum from your pension fund is that it will remain free from income tax.
Given that you will also have received tax relief when you contributed to your pension fund during your working life, the result is that you won't have paid any tax, at any point on the money.
If your income is greater than the income tax threshold once you retire, your retirement income will be subject to income tax in the same way as your pay while working.
Therefore taking your lump sum is a great way to get your hands on the cash in your pension fund without handing a cut to the taxman.
Of course, if your income will be less than the income tax threshold then you will receive it free from tax.
For the 2011/2012 tax year the income allowance for those aged 65 to 74 is £9,940, and £10,090 for those aged 75 and over.
More control
Withdrawing a lump sum from your pension fund will give you more control on what you do with your money.
Once you have received your lump sum you are free to invest it, spend it or use it in any way you see fit, rather than having to wait to receive the money in income across you retirement.
What are the drawbacks of withdrawing a lump sum?
Although there are numerous benefits to withdrawing a tax free lump sum from your pension fund, there are also a number of drawbacks that you need to consider.
Loss of future income
The main negative to withdrawing a pension lump sum is the subsequent loss of retirement income in future years.
This is particularly the case if you plan to use your pension fund to purchase an annuity that will provide you with a guaranteed income for the duration of your retirement. As, if you withdraw 25% of your pension fund, the income that you are able to secure is likely to be significantly lower.
However, there is no reason why you can’t use your lump sum to purchase a second annuity at a later date, although purchase life annuities do tend to be more expensive and generate a smaller income than standard annuities bought using a pension fund.
Why do you want the money?
Aside from the financial implications of drawing a pension lump sum, you also need to consider is exactly why you want or need the cash?
Repay debts?
A common reason for drawing a pension lump sum is to use the money to clear outstanding debts.
Depending on your circumstances using the lump sum from your pensions fund to pay off expensive loans and credit cards could make financial sense.
As well as saving you interest, it could also free up more of your limited retirement income to enjoy once you’ve finished work.
Clear the mortgage?
If you still have a balance outstanding on your mortgage then you may want to use your pension lump sum to pay off the remainder, or at least a significant chunk of, your mortgage.
Doing this would, in the same way as paying off other debts, free up a substantial part of your retirement income and mean that although your retirement income would be lower, you have to spend less of it on debts each month.
However, before withdrawing a lump sum and transferring the money to your mortgage account you will need to check that you are able to overpay your mortgage and you won’t fall foul of hefty early repayment charges.
A luxury holiday
You may feel that after years of working and contributing to a pension your tax free lump sum is a reward for all your efforts over the years in providing for your retirement.
However, while in an ideal world everyone could use their retirement lump sum to buy a new car or enjoy a once in a lifetime holiday, if you use up your lump sum in this way you could struggle further down the line.
Equally you may feel that this is your last opportunity to pay outright for a luxury purchase of this kind, especially if your income will be more modest once you’ve retired so you need to weigh up the real value of your plans.
Gift the money
You may feel that you want to use the lump sum you can withdraw from your pension fund to help out family or friends.
While this is certainly possible, you do need to consider how using the money you draw from your pension in this way will affect your inheritance tax liability.
Take a look at our articles: Gifting Money to Your Children: FAQs and How Do I Gift Money Without Being Taxed to find out more.
Other factors
In addition to the above factors, when deciding whether to take your tax free lump sum or not there are likely to be a number of other factors that come into play and influence your decision.
Your health
Although none of us can know how long we will live, it makes sense to assess your health at retirement and consider how long you are likely to survive when making your decision.
Essentially if you are in poor health and are likely to have little time to enjoy your retirement then taking a lump sum is likely to make more financial sense than if you are healthy and expect to live for many years to come.
This is because you will need to live for a number of years to make leaving your lump sum in your pension fund or cashing it in for an annuity financially worthwhile.
Can you take less than 25%?
If you have a specific reason for needing to take a lump sum from your pension, then you should also consider whether you need the full 25% as you do have the option to draw less.
While 25% is the number most often quoted in relation to withdrawing pension lump sums, this represents the maximum amount you can take and you are free to withdraw a smaller amount should you wish.
This fact allows you to be more flexible when deciding how much to take from your pension fund.
For example if you want the money to clear debts or for a specific purchase you can withdraw an amount to cover these costs and leave the rest in your find to generate a greater retirement income.
Speak to an IFA
If you are still unsure whether or not to withdraw you tax free lump sum then you should consider speaking to an Independent Financial Advisor to discuss your individual circumstances.
Read our guide: 5 Steps to finding an IFA you can trust with your money, for more help choosing an IFA who has your finances at heart.
