They say that wisdom comes with age, and while this may be true, you might feel that getting older doesn’t come with many perks. One though, might be the tax-free lump sum you’re typically allowed from your pension pot.
As the tax-free lump is usually 25% of a pension’s value it can be a significant amount of money, which could open up a host of possibilities. While this sounds attractive, care should be taken before withdrawing it all at once, as doing so could mean that your pension cannot support your lifestyle in retirement.
There is good news though, as you could sidestep this problem by taking your lump sum in small chunks. Read on to discover more, although before you do, we need to look at how the tax-free lump sum from a pension pot typically works.
The amount of tax-free cash depends on your pension
When Pension Freedoms legislation was introduced in 2015, it introduced the ability to take up to 25% of your pension pot without paying Income Tax on it. The rules for taking this tax-free amount vary depending on the type of pension scheme you have.
If you have a defined contribution (DC) pension, also known as a “money purchase scheme”, you can usually take up to 25% tax-free once you reach the age of 55 (rising to 57 in 2028). That said, some DC pensions may allow you to take more than 25%.
Any money you withdraw from the remainder of your retirement fund, whether as an income or as lump sums, will typically be liable to Income Tax.
If you have a defined benefit (DB) pension, also known as a “final salary” pension scheme, the amount of tax-free money you can receive depends on a “commutation rate”. This calculates your lump sum based on the amount of future pension income you are prepared to give up in order to receive tax-free cash up front.
Different pension schemes offer a different commutation rate, and the maximum lump sum you can take is determined by HM Revenue & Customs. As you can see, taking your tax-free lump sum from a DB scheme can be complicated, so speaking to a financial planner who can explain it to you is likely to be a wise move.
As DC schemes typically offer a 25% tax-free lump sum, we will concentrate on these for the remainder of the blog, which looks at the different ways you can take it.
You may want to take all your tax-free lump sum at once
Taking all the tax-free lump sum is a popular option, as it can provide a significant amount of money to help get you started in retirement. For example, you could use it to take holidays while you’re in good health, buy a new car, make improvements to your home or pay off debts or your mortgage.
Paying off debts or a mortgage could mean that you have more disposable income in retirement, which could boost your standard of living. The amount that is left in your pension pot after the lump sum is taken remains invested, which typically means that it is exposed to future growth potential.
While these are good reasons to consider taking all of your lump sum, care needs to be taken. Taking your lump sum in one go will significantly reduce the size of your pension pot, which is likely to reduce its growth potential.
As a result, your retirement fund may not be able support the lifestyle you want and could be depleted sooner than expected. The risk of this happening is increased when the stock market is jittery, as it has been for much of 2022.
Think carefully about taking your lump sum during economic downturns
Your lump sum is funded by selling investment units that are held within your pension pot. If the value of those units reduce because of a downturn in the stock market, more have to be sold to provide your lump sum.
As you have fewer investment units left in your pension pot afterwards, its future growth potential shrinks. Subsequently, your pension could struggle to provide the level of income you need in retirement, and might mean that your retirement fund runs out.
It’s worth bearing in mind a report by Sky News, which reveals that the International Monetary Fund (IMF) predicts 2023 will also see challenging economic times. This is likely to mean the stock market remains jittery for some time to come, although you might be able to reduce its effects on your pension when you take your tax-free cash. We will look at this next.
Taking smaller lump sums might be something to consider
You do not have to take your tax-free lump sum all at once. Instead, you can take it in several, smaller sums, which would mean that more of your pension pot remains invested.
As a result, more of your retirement fund will be exposed to greater growth potential, something that could help your pension pot recover when the stock market bounces back. Because of this, your retirement fund could provide the income you need to support your lifestyle, without the risk of it running dry.
If you are thinking of accessing your tax-free lump sum, you might want to consider taking a smaller lump sum to begin with, perhaps to pay off a debt, and delay some of your other goals such as buying a new car or improving your home.
Get in touch
If you are approaching retirement and would like to discuss the different ways you could access your tax-free lump sum, and which might be best for you, please contact us on hello@ardentuk.com or call 01904 655 330. As an award-winning financial advice company that was a 2022 VouchedFor Top Rated firm, you can be sure that we’re a bona fide company providing excellent advice and high quality service.
Please note
This blog is for general information only and does not constitute advice. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The information is aimed at retail clients only.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.
Workplace pensions are regulated by The Pension Regulator.
