Since the Budget there’s been plenty of talk about taking lump sums from pensions and using the money to spend on a variety of extravagances, most notably a Lamborghini.
The natural inclination is to take as much of the tax-free lump sum from your pension as possible. But is this always the right thing to do? Are there reasons to take less? Should you take nothing at all?
Read on to find out.
Reasons people take their tax-free cash
You want to spend it It’s perhaps one of the greatest myths that new pensioners take their tax-free cash and suddenly disappear on a world cruise, change their car or buy a caravan. But for some people, who have saved hard for their pension pot, this is exactly what they want to do.
It doesn’t take a genius to work out that taking the lump sum from your pension and spending it, will naturally reduce your income in retirement.
Before you take the lump sum do the maths to make sure you won’t be left short of income, both now and in the future when the effects of inflation have started to bite.
You should also consider other ways of financing the purchase; would you be better taking money from a savings account paying a poor rate of interest to make the purchase and using more of your pension pot to buy an Annuity? Only by doing the maths can you answer that question.
To repay an interest-only mortgage With the boom in interest-only mortgages over the past few years, many people have hit retirement without having a traditional repayment plan, for example an Endowment or ISA, in place.
For some people the only way to repay their mortgage will be by using the tax-free cash.
But before you repay your mortgage you should check the numbers to make sure it’s a sensible move. It might sound strange, but with interest rates so low, it can sometimes make sense not to repay debt. Obviously when rates rise this will change, but if you can make more from a savings account than you pay in interest, why pay the debt off?
Of course, for some people being debt free is more important than making a few pounds and others will find that their lender insists on the mortgage being repaid when they retire.
To repay other debt If you reach retirement with money outstanding on credit cards or personal loans using your tax-free cash to repay them can be a sensible move.
Not only will it free up additional income, because the monthly payments will stop, you won’t be paying relatively high rates of interest, which haven’t dropped significantly over the past few years, despite base rate being at an all-time low.
To create a tax-efficient income, part #1 If your main objective is to create the largest income possible from your pension pot, the temptation might be to use 100% of the fund to buy a Lifetime Annuity.
If you will be a taxpayer in retirement there might be a better way!
Rather than using all of the fund to buy a Lifetime Annuity, consider splitting the pension pot. Use the 25% tax-free lump sum to buy a Purchase Life Annuity (PLA) and the balance to buy a traditional Lifetime Annuity.
A Purchase Life Annuity (PLA) works in the same way as a Lifetime Annuity, except not all the income is subject to tax, which means you should get a higher net income compared to using all of the pension pot to buy a Lifetime Annuity.
To create a tax-efficient income, part #2 If you don’t like the idea of giving up access to your tax-free lump sum, which you will if you buy a PLA, you could put the tax-free cash into Individual Savings Account (ISA).
From July this year the annual ISA allowance will rise to £15,000, that means within less than 12 months a husband and wife could put £60,000 into ISAs; which could produce a tax-free income.
Remember too, that from July the full ISA allowance can be held in Cash; a significant step forward for savers and an effective increase to their allowance of nearly £10,000 a year.
To boost savings Everyone should have an emergency fund, but too few of us have enough money in savings.
Using your tax-free lump sum to boost your savings can make sense, provided of course you will be left with enough income to meet your outgoings.
So, should you take all, some or none of your tax-free lump sum?
There’s no way we can answer that here. But we can say that the question needs to be considered carefully before you decide and the answer is rarely black and white. Amongst other things you should consider:
- How much will your income be reduced by if you take the tax-free lump sum?
- Will you still be able to pay the bills each month?
- How will inflation affect your ability to pay your bills in the future?
- If you are planning to spend the tax-free lump sum, are there other sources of cash you could use which would be better?
- If you need to maximise income, could taking the tax-free lump sum help achieve this?
Everyone’s circumstances are different, which means the answer to the questions will also be different.
We’d strongly suggest you take advice on your options; there will be some you have considered, others you have discounted (perhaps mistakenly) and perhaps others you are not even aware of.
Our team of Independent Financial Advisers can advise you on the best option for your tax-free lump sum.