The much loved tax-free cash available from a pension plan at retirement is usually 25% of the value of the pension fund value.
What to do with it though?
Assuming that the plan holder doesn’t have any debt to pay off, the tax free cash lump sum can be saved (kept in an account paying interest), invested to generate income and/or further capital growth, or possibly even given away as part of an estate planning (and inheritance tax reducing) exercise.
Or an alternative, which I believe needs to be considered, even if ultimately rejected, that of spending the tax-free cash as if it were income.
Now to be fair a lot of people I meet are reluctant to spend capital as income.
After all it is hard earned and in retirement it is generally difficult to replace it once it has gone.
However, there are some advantages to spending pension tax-free cash as income.
The first is that (pretty obvious this one) it is tax-free.
Imagine a situation where the taxable income that the individual has sits nicely inside his or her personal income tax allowance.
By taking tax free cash and spending it as income over a number of years it could be that the individual has say a five year period totally free from income tax.
At the very worst they might have income which is taxable and spending the tax-free cash this way simply means they pay no more income tax than they absolutely have to.
By taking the tax-free cash but not buying an annuity or taking any unsecured pension (income drawdown) it also provides a pretty good investment target to aim at.
For example the client might say take the tax free cash and try to rebuild the pension fund back up to the original value over five or six years. Investment goals like this are measurable.
It also starts to inform us about the degree of investment risk that is needed to achieve that determined goal.
Of course there are some disadvantages as well.
There is continued investment risk for the fund that is not used to provide benefits and costs associated with the ongoing investment of those funds.
In addition in the event of the plan holder dying they will not have had any enjoyment from the balance of the fund.
In some circumstances, for example where the balance of the pension fund is paid to beneficiaries as a lump sum, there is also the ‘special’ tax at 55% that applies to the balance of the fund.
But that might have been payable anyway had the plan holder selected unsecured pension and taken an income.
As I said this is not fit for everyone but I have seen it work very well in practice for a number of clients. So it is not to be dismissed off hand but well worth considering.
Photo credit: Flickr/bokehburger
