More retirees are choosing to take a lump sum out of their pension and use Flexi-Access Drawdown to pay an income. But with fewer people opting to purchase an Annuity with their pension, is it a move you should be considering?
When Pension Freedoms were introduced in 2015, it gave retirees more flexibility. But it also made pension decisions more complex. If you choose not to purchase an Annuity, you’re responsible for ensuring that your pension provides you with the income needed.
One of the key decisions those approaching retirement need to make is whether to take a lump sum out of their pension fund. You can take up to 25% of your pension tax-free. You can take this tax-free portion in one go or in smaller withdrawals over a longer period. It’s an attractive option for many.
So, is it something you should take advantage of? Weighing up the pros and cons is crucial.
The advantages of taking a lump sum
- More flexibility: The biggest draw here is the flexibility that a lump sum provides you with. You’re not tied to an Annuity or an investment strategy that’s defined by your scheme. If you have a clear idea of how you’d like to use your pension, it can be a big draw.
- Invest how you want: If you want to continue growing the value of your pension, taking a lump sum gives you more freedom to invest in a way that suits you. This approach could yield higher returns, but, of course, there’s always the chance that your pension will decrease in value at points too.
- Support early years of retirement: The early years of retirement are often more active than the later ones. Perhaps you want to travel or take up a new hobby. Taking a lump sum from your pension can give you the cash injection needed to support your aspirations. Alternatively, you may still have debts, such as a mortgage, that you want to clear as you enter retirement. A lump sum may be one of the easiest ways to do this.
The drawbacks of taking a lump sum
- Pension needs to provide consistent income: While taking a lump sum out of your pension might seem like a good idea, you should balance this with the long term. Your pension needs to provide you with a sustainable level of income throughout your retirement years. Taking a lump sum out of it early on could affect your income for the rest of your life considerably.
- Pension value can decrease: If you choose to withdraw and hold the money in cash, for example in a savings account, the value can decrease in real terms. It can mean your spending power falls, in turn, affecting your retirement lifestyle. As a result, it’s important to decide how you’ll use the lump sum beforehand.
- May be liable for tax: You can take out 25% of your pension tax-free. However, beyond this amount, you may need to pay tax. With this in mind, effective planning is important to minimise the amount of tax you’ll pay.
Even after taking a lump sum out of your pension, there are still important decisions that need to be made. How you access the remainder of your pension, for example. Among your options are:
Leaving your money invested in a pension
After taking out a lump sum, this is one of the most popular options among retirees. In fact, 60% of pensions that entered drawdown last year did not see any further withdrawals once the tax-free lump sum had been taken, figures from the Financial Conduct Authority (FCA) show.
As you can take your lump sum from your pension at 55, you may not need to draw an income immediately. Leaving your pension invested in a fund is usually a good option if this is the case. It means the value of your pension will potentially continue to increase tax-free, providing you with more income once you access it.
Purchasing an Annuity
With what’s left in your pot, you can purchase an Annuity. The most common type of Annuity is a Lifetime Annuity; this provides you with a guaranteed income for the rest of your life.
The Annuity rate is the amount that you will be offered for each pound in your pension fund. These rates can vary between providers but will also be dependent on your personal circ*mstances, for example, your life expectancy. The income that you receive from an Annuity will be taxed.
Use Flexi-Access Drawdown
Flexi-Access Drawdown is where your remaining fund will be re-invested with the goal of providing you with a regular, taxable income. You’re able to set the income you want. But you do need to keep in mind that you need to take an income from this for the rest of your life.
Unlike an Annuity, the income you draw in this way isn’t guaranteed. You will need to manage your investments and regularly review the income you’re taking depending on performance. It can provide you with more freedom but it does come with risks too, for example, you may outlive your money.
You don’t have to choose just one of these options. You can take a mixed approach to suit your lifestyle and retirement plan. Contact us today to better understand which option is best for your pension.
FAQs
A lump sum also requires careful asset management. If you put the money into conservative investments so you don't lose money, the growth may not keep pace with inflation. However, if you invest in assets that can yield greater returns, you have a higher risk of losses.
What is the 6% rule for pension buyouts? ›
To determine this number, consider the 6% rule: which states that if your monthly pension offer is 6% or more of the lump sum offer, you should choose the perpetual monthly payment option. If the number falls below 6%, you might do as well (or better) by taking the lump sum and investing it yourself.
Is it wise to take a lump sum from your pension? ›
Things to think about. Taking out one or more lump sum won't provide a regular retirement income for you or for any dependants after you die. You need to plan how much money you can afford to take with this option. Otherwise, there's a risk you'll run out of money.
What should I do with my lump sum pension? ›
If you decide to take a lump sum in lieu of monthly pension payments, consider rolling it over to an IRA. A direct rollover from your employer's plan to your IRA provider (trustee to trustee) will not be subject to immediate taxation and may be the best way to preserve the tax-deferred status of this money.
Does a lump sum pension affect social security? ›
If two-thirds of your government pension is more than your Social Security benefit, your benefit could be reduced to zero. If you take your government pension annuity in a lump sum, Social Security will calculate the reduction as if you chose to get monthly benefit payments from your government work.
How much tax will I pay on my lump sum pension? ›
Mandatory income tax withholding of 20% applies to most taxable distributions paid directly to you in a lump sum from employer retirement plans even if you plan to roll over the taxable amount within 60 days. Note that the default rate of withholding may be too low for your tax situation.
How to avoid taxes on lump sum pension payout? ›
Investors can avoid taxes on a lump sum pension payout by rolling over the proceeds into an individual retirement account (IRA) or other eligible retirement accounts.
Should I take a lump sum pension buyout? ›
Whether you should take a pension buyout depends on when it's offered to you and your life expectancy, among many other factors. For most pensions, the earlier your employer offers the buyout, the better a deal it can be. But the closer you are to retirement age, the more you may want to prioritize monthly payments.
What is the golden rule for pensions? ›
With the golden rule, the ratio between your coordinated wage and the projected old-age pension at the time of ordinary retirement always remains the same, regardless of whether the rates are 1% or 2%. The golden rule is essential for calculating the appropriateness of pension plans.
Is it better to take pension, lump sum or annuity? ›
If you're really concerned about losing your pension because of the pension provider's financial situation or inability to pay out, taking the lump sum may end up being the more secure option. If your annuity does not have a cost-of-living adjustment, its purchasing power will decrease over time due to inflation.
For calendar year plans with a 1-year stability period, 2024 lump sums for this participant are 6%-17% lower than 2023 lump sums. This is on top of an even larger drop in lump sum values between 2022 and 2023.
Can I transfer my pension to my bank account? ›
For most pension schemes, it is not possible to access your pension until you are at least 55. You can, however, transfer to a new provider at any time. But if you're 55 or older, you can move your pension into your bank account. Even then, though, it is unlikely to be a good idea to take all of your pension in one go.
What is the downside lump sum pension? ›
You have to actively manage your pension amount. There is a large up-front cash drain to pay income taxes on the entire distribution if it is not rolled over to a traditional IRA or other eligible plan.
Where is the best place to put a lump sum pension? ›
Taxes: If you opt for a lump-sum payout, one option could be to roll it over to a traditional IRA and continue to defer taxes. If you take a lump sum and don't roll it over, you'll pay a large, single tax bill.
What is the penalty for taking a lump sum pension? ›
If you take a taxable distribution before age 59 1/2, the distribution is subject to a 10% early withdrawal penalty. However, if you roll over your lump-sum distribution into another retirement plan within 60 days, you won't be penalized.
What is the best pension option to take? ›
Option One: Single Life Pension Payout
While the single payout typically pays a larger amount than the joint life payout option, it may not be the best option if you are married. In fact, the joint life 50% pension payout option is the federally mandated option unless the spouse consents to another option.
Should I take a $44,000 lump sum or keep a $423 monthly pension? ›
In most cases, the lump-sum option is clearly the way to go. The main difference between a lump-sum and a monthly payment is that with a lump-sum option, you get to have control over how your money is invested and what happens to it once you're gone. If that's the case, then the lump-sum option is your best bet.
What is the main disadvantage of lump sum taxes? ›
Disadvantages of Lump Sum Tax
The main disadvantage of lump-sum taxes is that they are unfair to smaller businesses and those with lower incomes. The tax burden is higher for those with a lower income since they pay a greater portion of their income in tax than wealthier people.
