Thanks to reforms over the last ten years, pensions now come with more freedom than ever before. You can take some or all of your pension as a lump sum, once you reach the age set by your pension provider. However, with this new flexibility, there are new rules which you must observe. At Ascent Financial Planning , we can talk you through your options and help you choose the right retirement plan for you. But first, take a look at our lump sum guide.
Taking your pension as a lump sum
Most personal pension providers won’t allow you to access your pension until the age of 55 (rising to 57 in 2028). Once you get to this age you may have the option of taking your pension as a lump sum (depending on your provider).
How do lump sums work?
The good news: you can usually take a 25% lump sum tax-free. The bad news: tax will be applied to any further withdrawals. Taxable pension withdrawals are deemed income and are added to your total annual income. So, your income tax band may change depending on the amount you withdraw.
Remember that your pension is there to give you money for retirement so you can afford to stop working. Normally this means paying you a regular income, with money often paid to your nearest and dearest after you die. However, you might be able to cash in your entire pension so you get one lump sum. Your pension provider may refer to this as taking an Uncrystallised Funds Pension Lump Sum or UFPLS. This option usually means you’ll lose a large chunk of your pension to income tax, which could affect how much you have to retire on.
If you save or invest your lump sum, you might have to pay more tax on the interest or investment growth than you would leaving it in the pension. Growth within a pension is tax-free.
Your options
Of course, you are not obliged to take a lump sum. Depending on your provider, you can:
- buy a product that gives you a guaranteed income (sometimes known as an ‘annuity’) for life
- invest it to get a regular, adjustable income (sometimes known as ‘flexi-access drawdown’). For this, you will need to calculate sustainable withdrawal rates to ensure your money supports you throughout your retirement.
What are the risks of large lump sum withdrawals?
Although it’s tempting to go ahead and take that lump sum, there are several risks involved. This is why you should approach the task carefully.
- Losing investment growth: Once you take cash from your pension, it no longer enjoys tax-efficient growth. You can reinvest the money in the market but you will probably have to pay tax on the returns.
- Less retirement income: It stands to reason that if you take out cash now, you will have less money invested for later in life. This means you stand a greater chance of running out of money in retirement, plus inflation will reduce the real value of your money.
- The Money Purchase Annual Allowance (MPAA): Once you withdraw any taxable money from your pension, you trigger something called the MPAA. This restricts the amount you can contribute tax-efficiently to your pension from £60,000 a year to £10,000.
- Potential tax penalties: HMRC takes a dim view of people who attempt to put withdrawn cash back into their pensions. If HMRC believes this is the case, you could face a tax penalty of up to 70%.
Taking pension savings: the rules you need to know about
Once you reach 55 (or 57 in 2028) you can take your whole pension pot as cash straight away if you want to, no matter what size it is. You can also take smaller sums as cash whenever you need to.
However, the rules on tax on taking your pension are strict.
- You must be at least 55 (rising to 57 in 2028).
- You can only take 25% tax-free (known as the pension commencement lump sum’)
- Balance taxable: added to your income for that tax year
- Problem: taking too much in one go can push you into a higher rate tax band.
The rules for defined contribution pensions and defined benefit pensions
If you have a defined contribution pension, you can usually choose how and when to take your money. This includes the possibility of taking it all in one go, either as soon as you hit 55 (or 57 in 2028) or any time after.
If you have a defined benefit pension (sometimes referred to as final salary or career average scheme) you can usually only take one payment if:
- the value of all your private pensions is less than £30,000
- your scheme rules allow it
- you haven’t cashed in another defined benefit pension in the last 12 months.
Taking a defined benefit pension in one go is typically called ‘trivial commutation’ or a ‘trivial lump sum’ and means you’ll be giving up the promise of guaranteed income for life.
As experts on the subject, Ascent Financial Planning can explain the rules that apply to you.
How does tax-free pension cash work?
Once you approach the age of 55 (rising to 57 in 2028), you’ll be asked what you want to do with your pension. You don’t have to do anything with your pension, but if you choose to take out a lump sum in cash you’ll want to be aware of the tax implications. You can usually take up to 25% of the amount built up in any pension as a tax-free lump sum. The most you can take is £268,275. This is called a ‘lump sum allowance’ or LSA. You’ll pay tax on the remaining amount, as discussed earlier.
If you’re receiving money as a serious ill-health lump sum before you’re 75 (typically if you’re expected to live less than a year), it does not count towards the LSA.
Instead, you might get it all tax-free up to a limit of £1,073,100. This is called the lump sum and death benefits allowance (LSDBA).
Full lump sum withdrawals v alternative options
Taking your pension in one go as a full lump sum gives you maximum freedom financially. However, it comes with some downsides. For instance, you might have to pay a higher rate of tax if you take the full amount. Furthermore, your pension provider might charge you for withdrawing cash from your pensions pot. It’s best to check with them about this.
However, there are alternatives. You could look into phased withdrawals or drawdown where the money is invested in something called a flexi-access drawdown fund. This allows you to:
- Make withdrawals
- Buy a short-term annuity (which will give you regular payments for up to five years).
- Pay in (however, you’ll pay tax on contributions over the Money Purchase Annual Allowance).
You can also use some or all of your pension fund to buy an annuity at any time. Annuities are insurance policies that are bought with money from your pension pot that provide a guaranteed regular income. You have the choice of monthly or annual payments. However, be aware that annuities can be inflexible if your circumstances change in the future.
What are the financial and tax risks of taking large lump sums?
While taking a large lump sum gives you benefits such as flexibility, reinvestment opportunities and the ability to repay debts, there are risks involved.
- Running out of money. Once withdrawn, the funds may not last your lifetime. There’s no guarantee of a sustainable income.
- Higher tax bills. Taking a large lump sum can push you into a higher tax band.
- Loss of regular income. Unlike annuities or drawdown, a lump sum doesn’t provide ongoing payments.
- Inflation erosion. £100,000 today won’t have the same buying power in 20 years.
In other words, the pension lump sum advantages and disadvantages must be weighed carefully against your long-term retirement needs.
The value of investments and pensions and the income they produce can fall as well as rise. You may get back less than you invested.
Tax treatment varies according to individual circumstances and is subject to change. Tax Planning is not regulated by the Financial Conduct Authority
Getting professional advice
Everybody’s pension situation is different and it is wise to get professional, regulated advice from experts. At Ascent Financial Planning, you’ll find a team of consultants who can give you an accurate and realistic picture of your circumstances and help you decide on the right option for you. Would a full withdrawal give the flexibility that you need? Or would a phased (or partial) withdrawal make more sense in your situation? Whatever the answer, we’ll talk through your choices, the risks, the potential pitfalls and the tax implications so you can make the best decision for you.
Next steps
If you’re ready to find out more about your pension options, especially the possibility of taking a full or partial lump sum, book a consultation with Ascent Financial Planning. Based in North Wales, our experts will help you understand what can be a complex subject so you can make an informed choice.
