Your Tax-Free Defined Contribution Pension Lump Sum Explained

From the 6th of April 2015, those with defined contribution pensions have been granted pension freedom! But is this as promising as it sounds?

During last year’s Budget, the Chancellor announced the decision to allow those with private pensions to withdraw as much as they liked from their pension pot in cash when they reach 55. For those eligible, the changes mean that retiring savers are no longer ushered in to purchasing an annuity. As a retiree you will be able to take what you want, when you want from your pension funds, however those who decide to act on the new options will need to carefully consider the decision.

Previous pension rules have allowed those with defined contribution pensions to withdraw up to 25% of their current pension pot as a tax free lump sum (or a pension commencement lump sum). This will remain the case, any withdrawals of 25% or under remain tax-free but anything above could be subject to income tax. Unsurprisingly, the reconstruction of the rules around pensions are set to generate around a £3 billion return for the government as many of us move around our pension pots - paying income tax whilst doing so.

How Taking a Cash Lump Sum Will Affect Your Retirement Income

So, the changes to legislation are allowing for more freedom with your hard earned nest egg but what is the right thing to do? A tax-free lump sum would be tempting for many but it is important to bear in mind how withdrawing from your pension will affect your retirement income. We’ve weighed up the pros and cons;

The Pros of Taking a Lump Sum from Your Pension

  • It’s a chance to get your hands on a large sum tax free! You can take up to 25% without having to pay a penny in tax. Remember, you will pay your highest tax rate on any sum over this threshold but you have the freedom to access more of your money if you wish to do so.
  • As part of the pensions shake-up, free impartial advice will be offered as standard - giving you an impartial expert voice to assist with your planning your financial future.
  • Freedom to spend your money the way you want. You could take the holiday of a lifetime, buy a new car, pay off your mortgage or invest it in a deposit for your dream retirement home or even to help your children and grandchildren invest in their future. The possibilities are endless!
  • Annuities are still very much an option. If you only withdraw a lower percentage from your pension pot you can still invest the remainder in an annuity as you would have done with the full balance.
  • You could generate more income from your pension by moving the money in to an ISA or investing in a stock portfolio.
  • If you are worried about your health, withdrawing a lump sum could make more financial sense for you rather than handing over all of your pension savings for an annuity.

The Consof Taking a Lump Sum from Your Pension

  • Taking a lump-sum from your pension will deplete your monthly retirement income.  Always take the time to consider how much you can realistically afford to withdraw.
  • Withdrawing the full balance of your pension pot as cash could mean that you’ll lose out on the chance to set up regular retirement income.
  • Taking your pension as cash will also affect your state benefit entitlement. Pension credit payments for example will be reduced significantly.
  • Retirees with middle incomes could lose out to taxation. If your usual annual personal income and pension fund total is more than £42,000 you will face the higher rate of tax on withdrawals of more than 25%.
  • Those in a defined benefit scheme will face restrictions to the process of withdrawing a percentage of their pension balance. If you are working in the private sector may be able to transfer to a personal pension to cash in but will be required to seek financial advice before being able to proceed. However, if you are a public sector worker, such as a doctor, nurse, teacher, member of the police force, etc., you will not be able to take any of the value of your pension in cash.
  • Some pension providers will be allowing customers access to their pension funds at any time. Some will limit the number of withdrawals per year. Some will charge for the privilege of withdrawals and some will not allow access at all, meaning their customers will have to make the decision to cash in the full pot or transfer the funds to an alternative pension scheme or annuity.

Whatever you decide to do with you pension pot, always seek financial advice before making your choice. Your pension is your hard earned investment in your retirement years. Take the time to think it over and make the decision that will ultimately be of the most benefit to you. 

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