Should You Take Your 25% Tax-Free Lump Sum?
In April 2015, the UK government introduced the “Pension Freedoms”. These new rules to the pensions regime had many far-reaching implications, but one of the big changes was that over-55s were then able to withdraw as much as they liked from their pension pots.
In fact, the Pension Freedoms allow each person over 55 to withdraw up to 25% of their pension pot, tax-free. Indeed, official figures show that these sorts of withdrawals are becoming more and more popular, with £2.75 billion withdrawn from pensions flexibly in Q2 of 2019 (a 21% increase from £2.27 billion in Q2 2018).
Pension withdrawals are understandable. After all, if you have a £300,000 pension pot and you suddenly have the option to immediately gain access (tax-free) to £75,000, lots of people would be tempted by that! However, many people are withdrawing without taking professional financial advice beforehand and lots of people are doing so out of impulse – sometimes regretting it later.
Don’t Just Rely on Your Scheme
Your pension provider might have been great in helping you save for retirement throughout the course of your career (or it might not). It might be particularly tempting to stay with them in order to get access to your 25% tax-free lump sum since this can appear to offer the least troublesome way to do so.
However, it’s important not to make the assumption that this scheme is going to be the best option for you when it comes to pension withdrawals. Some pension schemes (particularly older ones) might not allow you to take a flexible income from your pot (i.e. Flexi-Access-Drawdown). Others will permit you to do so, but their charges will vary quite significantly.
This is where seeking independent financial advice (such as from one of our team in Lincolnshire) can really help. After all, an experienced set of eyes can help you identify whether your scheme is offering you a good deal, and offer some attractive alternatives to you. Indeed, it is possible that moving to a different scheme could boost your retirement income by a good amount. According to the FCA, it could increase by as much as 13%.
To Withdraw, or not to Withdraw?
The decision of what to do with your 25% tax-free lump sum can be a difficult one, and it can really help to consult a professional financial adviser to help you look at this in light of your wider financial plan. After all, your decision will be largely determined by your own unique financial goals and circumstances – both of which you might need help determining precisely.
Broadly speaking, however, there are some positive and negative factors to take into account. First of all, here are some possible justifications for taking some/all of your 25% tax-free lump sum after the age of 55:
- Paying off debts. It might be that your monthly income has been strangled for some time by large interest payments on various loans, debts or finance plans you agreed to many years ago. Taking your lump sum can offer an attractive way to reduce these, or even eliminate them entirely.
- Building up your emergency fund. Generally, financial advisers and planners will recommend that you have at least 3-6 months’ worth of your living costs reserved in short-term savings. This can help to cushion you and your family in the event of a large, unexpected expense (e.g. a broken boiler/roof) or in the event that the household income is reduced due to job losses.
- Well-earned enjoyment. We understand that life isn’t all about saving and investing. Sometimes, it’s good to enjoy the money and wealth you have earned. For instance, perhaps some of your lump sum could go towards a family holiday or a new car? However, it’s important to make luxury spending decisions with your eyes fully open. Generally speaking, if you are already on track towards your own financial goals, then it is often easier to justify a larger luxury spend to yourself and to your family. If you are not on course, however, then the money might be better spent getting you back on track.
Secondly, here are some broad reasons to consider not taking your 25% tax-free lump sum (or, not taking all of it at once):
- Reduced retirement income. This is probably the most important reason to hold off acting out of impulse on this big decision. Remember, if you take 25% of your pension pot then the remaining 75% is intended to provide you with an income in retirement. This might involve using the amount to buy an annuity (i.e. guaranteed income for life), or drawing an income gradually from it over time (i.e. “Income Drawdown”). Naturally, taking 25% of your pension pot at the age of 55 will likely mean less money to buy an annuity to draw an income from in retirement. This is where you need to be particularly careful, and would probably benefit from speaking with an independent financial adviser. After all, you do not want to be in a position where you take too much money from your pension and potentially run out of money in retirement.
- MPAA penalties. If you are planning on continuing to contribute to your pension pot from the age of 55, then you need to be careful not to be hit by an “MPAA penalty” by taking more than your 25% tax-free lump sum. Remember, most people can contribute up to £40,000 per year to their pension (or 100% of their annual salary – whichever is higher) without facing tax. This is known as your “annual allowance”. However, once you start flexibly accessing your pension benefits from the age of 55, the Money Purchase Annual Allowance (MPAA) rules usually kick in. This limits the amount that you can continue to contribute to your pension, tax-free, to £4,000 per year in 2019-20.