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The Tax-Free Lump Sum

The Tax-Free Lump Sum – and how to spend it

One of the advantages of saving money into a pension is that – despite the already generous tax breaks available to those who pay into them, they also get an extra kicker from the Inland Revenue: 25 per cent of the pot they have saved up can be taken as a tax-free lump sum.

Think about it:

• You are a higher-rate taxpayer and you have just paid £60 into a pension
• The Inland Revenue rounds that up to £82
• You then claim back another £18 on your tax form – or if the money has gone into a company scheme, your pot is rounded up to the full £100
• You then stop work and can take 25% of that in tax-free cash. Significantly, the taxman is letting you have back not just 25% of YOUR contribution, but of the full assumed amount of the pension, including what the Inland Revenue already paid in
• Using the example above, you would get back £20.50 free of tax on top of the £18 you reclaimed (£38.50 in total), while still using £61.50 to buy an annuity

By any measure, that is good going.

So what should you do? There are a number of options – and permutations between them:

Take it and spend it

The attraction of this is that it will probably come to more cash money than you have probably ever enjoyed in your life. It may be time to dust off those guidebooks and set of on the world trip you always promised yourself, buy the car you always lusted after, or even renovate the house in a way you could never have afforded before.

Use it with the rest to buy an annuity

The potential advantage here is that it allows you to use your fund’s larger size to squeeze a better deal from annuity providers: you are generally more likely to get a higher rate for a £200,000 lump sum than a £50,000 one.

It also “secures” your income: no more worrying about whether you should do something with that money, if you have made the wrong choice, or about falling share prices. Now you are committed, you know precisely what your pension will be in retirement.

Take it and invest it

The advantage here is that by taking the money, you are free to invest it how you want. The money need not go into an annuity: you can place it into ISAs, which pay tax-free income – unlike pensions – and which can be left to your estate in the event of your death.

If the lump sum is too large to do so over one year, you can drip-feed it in over two or three years, perhaps taking advantage of your spouse’s tax-free ISA allowance too.

You have a choice over that money’s investment strategy – unlike buying an annuity.

Use the tax-free cash for a “purchased life annuity”

A purchased life annuity is one you buy with your own cash, including the tax-free lump sum you have taken.

One of the advantages of doing this is that while income from a standard pension annuity is subject to income tax, part of the income from a purchased life annuity is treated as a return of your own capital, and is not taxed.

This portion is known as the capital content and is based on the annuitant’s age. The older you are when you purchase your annuity, the higher will be this capital content and the lower the tax. A 40% taxpayer might end up paying well below 5% tax on that portion of his or her income.

You can take out a purchased life annuity either for a set number of years or until your death, with the option of a continuing pension to be paid to your surviving spouse after your death.

With these options, there is the opportunity of “pick-and-mixing” and using some of each strategy as it suits you. But it may be worthwhile talking to an independent financial adviser (IFA) who can help you reach a decision.

More pages

Page 1: The Tax-Free Lump Sum – and how to spend it
Page 2: How to use your lump sum

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