When you are approaching retirement, you will have lots of decisions to make about your pension scheme. One of these decisions is whether you should take your lump sum or not.
What is a tax-free lump sum?
When in employment, the government try to encourage you to save for retirement. They offer a top-up to your contributions. Any income drawn from this pension is liable to tax. The exception is the 25% lump sum, which you can take tax-free on retirement.
When can I withdraw my tax-free lump sum?
When you can take this lump sum, whether it is at Normal Pension Age, or if you take early retirement, is dependent on your scheme. It is a good idea to seek advice from an independent financial advisor for a detailed understanding of your pension scheme.
In general, you will not be able to withdraw your lump sum before the age of 55. It is possible, but you are likely to face a huge tax penalty – likely a 55% taxation. If a scheme offers you access to your pension early, you should show extra caution, as this is how scams tend to work. The money is moved into high risk or dubious schemes. You cannot do this with a teachers’ pension scheme.
If you are in poor health, you may be able to claim your lump sum earlier.
Should I take this lump sum?
A defined contribution pension (DC) is more straightforward than a defined benefit (DB) pension. In a DC scheme, you can take up to 25% tax-free and the rest of the scheme is crystallised, and you will be prompted to make a decision regarding what to do with the rest. You could keep the rest of the fund invested, with you receiving an income drawdown plan. You could use the fund to buy an annuity, or you could cash in your entire pension, with the rest being subject to taxation.
This means you have much more flexibility when it comes to taking a sizeable amount of money at retirement.
It might be best to keep the total fund together and to opt for the flexibility of an income drawdown. Alternatively, you could receive this gradually as a UFPLS (uncrystallised funds pension lump sum) with each payment providing 25% tax-free benefits and the rest taxable at your highest marginal rate.
The DB, usually called a final salary scheme, works out your lump sum using a commutation factor. The higher the commutation factor, the better the deal you are getting. This factor is devised by an actuary who makes sure the scheme can continue to pay out what it has promised. Teachers tend to have a commutation factor of 12, while some private sector schemes are likely to be more generous, with a factor of 15.
But, is it worthwhile? According to Which? Magazine, and as a rough calculation, potentially no. At a commutation factor of 12, it could be possible for your pension to be worth more in annual income than the lump sum within 11.5 years.
Should you take your lump sum? You might be better off in the long term by taking your entire fund as income. However, it depends on your plans. Imagine you want to take a luxury holiday on retirement… or you want money to invest in a consultancy business… or you want to pay off the mortgage. Then, taking your lump sum could make much financial sense. Everyone’s situation is personal; therefore, it is a good idea to speak to an independent financial advisor before deciding
The content in this article was correct on 19th May 2019. You should not rely on this article to make important financial decisions. Teachers Financial Planning offers advice on the Teachers’ Pension Scheme. Please use the contact form below to arrange an informal chat with an advisor and see how we can help you.