When is the right time to take your tax free cash sum?
The tax-free lump sum has always been a part of the pension landscape.
I worried that its tax-free status was about to change when HMRC started calling it the “pension commencement lump sum”, and this was proven correct when the pension wealth tax (the Lifetime Allowance Charge) was introduced, with the result that not all pension commencement lump sums are tax free anymore.
But, for most of us, the lump sum is still free from tax, so I’ll persist with the catchier but slightly less accurate “tax free cash sum” description in this post.
For most of us, the tax free lump sum will be 25% of something.
The something, which the 25% is applied to, is your “uncrystallised pension fund”. For a lot of people, that’s 25% of the value of the pension fund; but, if you have already crystallised some of your pension fund (i.e. taken some money out), it will be less than that. I want you to read on, so I won’t explain how the crystallised fund is calculated here!
If you have an older company pension, you might be entitled to more than 25% of its value as a tax free lump sum (some people can have 100% of their pension fund as a tax free lump sum).
Importantly, you can choose to decide when you withdraw your tax free lump sum. You have to be 55 before you can draw it, but, once you get to 55, you can have the money at any time.
The prospect of having a tax free lump sum is pretty appealing. It sounds pretty daft to turn it down.
But, sometimes, it’s best not to take it at all, and, most of the time, it makes sense to wait for the right time to take it.
It’s important to remember that:
-You don’t have to take your tax free lump sum in one go. You can stagger its payment over several years, giving you, effectively, a tax free income.
-You can leave the rest of your pension invested – you don’t have to buy an annuity or start taking an income when you draw a lump sum out of your pension.
-Your pension fund is free from inheritance tax on death.
-You don’t pay tax on the income or capital gains achieved by the investment you hold in your pensions.
-Charges for most pensions are pretty low, compared to other investments
The combination of these factors means that there’s no point in taking money out of your pension as a tax free lump sum, only to put it in a taxable investment – unless you are keen to increase the amount of tax you pay!
It’s probably true that calling it a “tax-free” lump sum has resulted in a lot of people taking it out and then paying more tax than they would have done if they had left the money where it was!
It usually makes sense to draw out your tax free lump sum, if you have borrowings to repay, or to prevent you from borrowing money at a high rate. If you aren’t confident that your pension will produce a higher return, after charges, than the interest rate on the money you have borrowed, then you might as well use the tax free lump sum to pay off the loan.
But what if you have planned well, and you arrive at retirement without any borrowing, and you don’t need to withdraw a large lump sum from your pension for anything in particular?
The popular and obvious choice has been to draw the lump sum at age 75. When you are 75, the tax position of the remaining pension fund worsens, HMRC will demand some information, and some pensions can’t continue beyond 75. This combination often provides the trigger to draw the tax free lump sum.
However, the logic of drawing the lump sum at 75 is questionable. After all, life expectancy at age 75 for a man is still 13 years, and for a woman, 14 years, so, if the plan is to give the lump sum away and use the seven year rule to avoid inheritance tax, then there should still be plenty of time after age 75 to make the gift (remember that pensions are inexpensive and tax-efficient, so there is a benefit to leaving the money in the pension).
And, just because you are 75, there’s no point in taking money out of your pension only to invest it in something less tax-efficient.
Like so many other things, we think that the timing of the lump sum should be determined by your Financial Plan.
It should take account of your personal objectives and requirements, your tax position and your financial resources. It can be particularly helpful to have a year or two without taxable income (as this can allow you to save capital gains tax, for example), and the tax free lump sum can help you finance your expenditure while you are doing this.
Only a professional, personal retirement plan can ensure that you make the most of the resources you have built up before you stopped work.When is the right time to take your tax free cash sum? @philipwiseicfp shares some things to think about in this new blog post Click To Tweet