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When you reach the time when you can pat yourself on the back for forty-odd years of a good job well done, and you sit back to reap the accumulated rewards, you may be quite taken with the idea of getting a tax-free lump sum of up to 25% from your pension pot. When not to take the lump sum However, if you take the lump sum your annuity might be disproportionately small. This is particularly likely if you're in a final-salary scheme. Many such schemes tempt people with a pile of cash up front, but they don't tell you that the benefits you're giving up are worth so much more. Standard Life believes that up to 250,000 of these people take the lump sum every year. They estimate that in many of these schemes, for every £1,200 you take as cash, your pension income reduces by an additional £100. To put it another way, you might have a pension pot of £600,000, which provides an income of, for example, £30,000 per year. You're receiving an income worth 5% of the pot. If you take your 25% lump sum (£150,000), then, using the same rate of return, you'd expect to get £22,500 a year from the remainder of the pot. But, according to Standard Life, you lose £100 for every £1,200 you take, so you get just £20,625. That's almost £2,000 less than you anticipated. When to take the lump sum Sometimes taking out a lump sum can actually increase your retirement income! If you're not in a scheme that penalises you as heavily as in the above example, you can take your lump sum and shop around for life annuities. These are like pension annuities, with a few key differences. Firstly, life annuities pay less income from the same size lump sum (usually 80-90%). On the other hand, this is often more than offset by their much more favourable tax treatment. You pay income tax on pension annuities in the same way as you do on your salary. With purchased life annuities, part of the income is treated as a return of capital, so it's tax-free. The balance is taxed like savings income at 20%, which compares well with the 22% or 40% you'd pay for income tax. As a rough guide, if you have a pension pot of £400,000 and you don't take out a lump sum, that quarter of the pot might convert into roughly £8,000 a year if you're 65. After tax at the basic rate you get just over £6,200 per year. At the higher rate you get £4,800. If you take the lump sum and choose a good life annuity, you'll get a return before tax of say £7,200, which doesn't compare well with the £8,000 from a pension annuity. But after much lower taxes you could expect to receive about £6,900, so you've gained another £650ish every year, or £2,100 for higher rate payers! All this just for a day's work looking around. Before you take out a lump sum ask your pension administrator what effect it'll have on your monthly pension income. And compare your net income, rather than your gross, if you look to acquire a life annuity. Get more help in our Pensions centre.
