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Pensions: should you take tax-free cash when you retire?
One of the big benefits of pensions is the 25% tax-free cash lump sum you can take from your pot when you retire. But is this the right thing to do?
by Michelle McGagh on Dec 14, 2012 at 15:03
One of the big benefits of pensions is the 25% tax-free cash lump sum that you are allowed to take from your pot when you retire.
This lump sum is truly tax free as you will have paid no tax on the money that went into your pension and you will pay no tax when you take out up to a quarter of the money that has grown inside the plan.
Of course, the remainder of your pension savings is subject to income tax.
But although it feels good to get your hands on your tax-free cash from the pension, is it the best thing to do?
Yes and no: the impact of low annuity rates
Traditionally, most people would use their pension savings to buy an annuity when they retire. The annuity would pay an annual income - your pension - until death. However, annuity rates have plunged as people have lived longer and interest rates have fallen. This means anyone retiring today needs a much bigger pension pot to provide a decent pension than if they had retired 10 years ago.
Given this fact, you can make a case for taking the tax-free cash from your pension and for leaving it in your pension pot.
Arthur Child, managing director of Arch Financial Planning in Guildford, says one way to boost your income is not to take your tax-free cash as the more money you have in your pension pot then the bigger the annuity you can buy.
On the other hand, he says you could invest your tax-free cash and generate a better return than you would get from an annuity.
For people saving into a personal pension, Child says taking the tax-free cash may prove the better option.
‘Annuity rates are so low for personal pensions that taking the tax-free cash is probably the right answer,’ he said.
‘A 65-year-old man who wants an inflation-linked annuity will probably get an annuity rate of 4%. If you take out the tax-free cash and invest it you could easily get 4%.’
When not to take the cash
However, there are circumstances where tax-free cash should not be taken, says Child. If you are part of a generous defined benefit, or final salary, pension scheme from your employer then the value of keeping the cash in your pension pot and taking it as income is much higher than taking the cash.
‘You do not want to take your tax-free cash if you are in a final salary pension scheme. What you lose in pension income and what you gain in cash is not worth it,’ said Child.
Also if you have a guaranteed annuity rate written into your pension policy then you should not take the tax-free cash either as you lose out on a significant amount of income.
‘If you have a guaranteed annuity rate, say for example of 8%, then you would be crazy to take the tax-free cash and give up the income because there is no way we could generate an 8% return by investing the cash.’
What do you need the money for?
Child said most retirees automatically take the 25% cash without asking themselves whether they need it.
In his experience, Child says people typically fall into two categories.
‘Some people find the cash burning a hole in their pocket and they spend it on cruises and cars but once that money is gone, it’s gone, whereas pension income from an annuity keeps coming,’ he says.
But he adds: ‘On the other hand there are those who take the tax-free cash and have a small pension but £100,000 sitting in deposit in the bank and they are too scared to spend it although they are living hand to mouth. Most people are better off having a higher income and for them income is more valuable.’
Don’t take it all
When it comes to taking tax-free cash, it’s not an all-or-nothing situation, you can choose to take less than 25%.
‘If you have £25,000 still left on the mortgage then pay that off [with the tax-free cash], but do you need anymore than that?’ asked Child.
It is easy to change the amount of tax-free cash you take, he added.
‘If you are not using an IFA [independent financial adviser] who will do it for you, phone your life company and they will send you a new annuity quote. They typically send a default quote with the income you would receive if no tax-free cash is taken and a quote with 25% tax-free cash taken and people think they are the only options they have,’ he said.
And what about the tax conundrum; surely leaving money to be taxed when you can take it tax-free is a bad idea?
Child answers: ‘Pension income is taxed but most people in retirement haven’t got enough income to pay a lot of tax – as a couple you have to earn £20,000 a year before you are taxed.’
He added that an IFA will help you to decide whether you need to take your tax-free cash, get the best annuity deal and ensure you aren’t paying too much tax.
‘To sort out an annuity an IFA will charge you between £500 and £750 but you could be a lot better off after.’
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