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Is it worth taking the maximum tax free lump sum (pension commencement lump sum) from my pension scheme?

Updated on November 1, 2016
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Cruncher is the pseudonym of an actuary working in London with experience in Insurance, Pensions and Investments.

A pile of cash in the British Museum
A pile of cash in the British Museum | Source

Many countries, such as the UK, allow you to take a lump sum from your pension scheme when you retire. In the UK this amount (known as the pension commencement lump sum) is free of tax. In the UK you can generally take up to one quarter of your pension pot in this way.

You can now usually also choose to "draw down" money from your pension scheme if it is a money purchase (also known as defined contribution) pot. But you will be taxed on this. Money drawn down is taxed as income when it is taken - so it's generally better not to draw money until you want to spend it.

But the commencement lump sum is tax free and you can have it as soon as you retire. So taking the maximum amount is a no-brainer, right? Unfortunately nothing is that simple. You have to think about how taking the cash now will affect your income in the distant future. It will also depend on your circumstances and exactly what sort of pension you have.

This article can help you think about your choices but it is not advice, and isn't tailored to your individual needs. If you feel you need to talk about your option and what best suits your personal circumstances find an independent financial adviser or chartered financial planner in your area.

This article is also based on current UK law and tax system - but the ideas will be similar for other countries that also offer the lump sum option.

What are you giving up by taking the cash?

Although it's tax free cash, it's not free cash! You are giving something up - future income from your pension. For most people that means giving up part of a guaranteed income for life for cash now. But none of us know how long we will live. So you can't be sure, even with the tax break whether you will be better off overall taking the cash now or the lifetime income.

You should also consider whether you need that lifetime income as "insurance" against running out of money if you do live to be very elderly by which time you may have spent the lump sum.

For those two reasons (because you can't predict how long you'll live, and because a lifetime guaranteed income is, partly, "insurance" against running out of money when you are very elderly) you have to think seriously about how much of your pension you want give up for a pension commencement lump sum.

Leaving your money in your pot can make it grow quicker - but you might have to pay more tax.
Leaving your money in your pot can make it grow quicker - but you might have to pay more tax. | Source

Is taking the cash "value for money"?

OK, let's assume for a minute that you are comfortably off so could use your savings if you live longer than expected, and all you care about is deciding which option would be expected to give you the most cash in your hand over your lifetime (on average). You might expect that if you took your cash lump sum and bought a pension with it, you would get the same income as you have given up in your pension scheme. But it isn't that simple! It depends on what kind of pension you have.

There are two broadly two kinds of pension schemes: those where you build up a pot of money and then use that to buy an income when you retire (these are called defined contribution or money purchase schemes) or schemes where you build up an amount of pension based on a formula (these are defined benefit schemes, for example final salary schemes or career average schemes). Taking tax free cash works differently in each of these two types of scheme.

Taking cash in defined benefit schemes

These schemes pay you a pension when you retire based on a formula. This formula usually involves your salary (perhaps you final salary or your career average salary). That means that there is no "pot" of money that you can take your tax free cash from!

Instead you have to "commute" your pension into cash. This is a bit like converting dollars into pounds at the travel agent. There is an exchange rate. That rate is usually set by your pension scheme.

The problem is that there is no guarantee that this "commutation rate" will be set equal to the amount of income you would expect on average to get from the scheme in the future. It will usually be less. This is partly because your cash would be tax free, and your pension would not be so the scheme doesn't have to offer such generous terms to make it worth your while taking it (in other words they keep a bit of the tax break for the scheme) and partly to protect the pension scheme from running out of money.

All together this means that (ignoring tax) for most defined benefit schemes the tax free cash you get is less than it would cost you to replace the pension "commuted" from somewhere else! But even though the cash is "tax free" it still doesn't mean it's a good deal. You might still expect to get much more in the long run by taking it as pension instead of cash. But it all depends on the "commutation rate" set by the scheme.

This is a complicated calculation. The only way for most people to work through this is to take independant advice.

Drawing down cash from your pension is like an ATM withdrawal - once it's out, you can't just stuff it back in the way it came.
Drawing down cash from your pension is like an ATM withdrawal - once it's out, you can't just stuff it back in the way it came. | Source

Taking cash in defined contribution schemes

For defined contribution schemes it is much simpler. You have a pot of money which you convert to a pension income when you retire so the pension you give up is exactly the cost of buying the pension. Remember that this cost varies over time and depends on the kind of pension income you want to get (see this article here for the things you should think about when buying an annuity). So, on average, taking the tax free cash should be a good deal, as you get the tax break and should expect to come out even compared to the cost of buying an annuity.

If you plan to draw down money from your pot instead of (or as well as) buying an annuity then you have to pay tax on the drawn down amount. Therefore it generally will be better to take the maximum amount tax free at the start. But make you consider your own circumstances - there may be specific situations where it might not be better for you.

Thinking about investing money after you retire?

Have a look at these useful articles about different investment classes and their plusses and minuses.

Taking cash if you plan to go into income drawdown

There is one important exception. If you have a defined contribution pension and plan to take income drawdown. Income drawdown is where instead of buying a guaranteed income in the form of an annuity from an insurance company you leave your pot invested and just take money from the pot. This is riskier than buying an annuity and should generally only be done by the wealthy or the financially sophisticated.

But if you are going into income drawdown, one of your key objectives may be to maximise tax relief. If you take tax free cash, you do get the tax relief from income tax. However if you invest that money future income and capital gains will be subject to tax. However if you leave the money in your pension pot you will continue to build it up free of tax. But then you will have to pay tax on the money either when you draw the income down or when you die.

This is a situation where you definitely should take independent advice which will be tailored to your individual circumstances.

Conclusion

Taking the biggest tax free pension commencement lump sum you will make sense sometimes. It is tax free and you can use the money straight away. But unfortunately it's not an obvious decision. You should consider carefully whether you can afford to give up the future income and whether the particular deal you are offered is good value for money.

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