Some of those who explore taking their full pension savings as a cash lump sum may find that they usually receive less than they thought.

Before you make any decisions, we strongly recommend you get together all the information you need and take advantage of the help and support available to you. The Government has set up Pension Wise to provide free and impartial guidance for those aged 50 or over who are considering their retirement options.

Why might I get back less than I thought?

Generally, the first 25% of any withdrawal from your pension pot is tax-free, anything over this is taxed as if it's income earned in the month it's paid. The way you’re taxed and how much you have to pay will depend on your individual circumstances and how you withdraw your money. Please speak to your financial adviser for further details.

Taking all your cash at once, where you haven't already taken the tax-free cash, can impact you in two ways:

  1. The lump sum (excluding the first 25%) and any other earnings you have will be added together for tax purposes and may result in your total earnings moving you into a higher tax bracket (see example below). This could leave you with less in your pocket than you expected.
  2. In most cases your pension provider will have to take tax using an emergency tax code which could further reduce the cash lump sum paid out. Depending on your circumstances you may have to claim back any overpaid tax from HM Revenue & Customs (HMRC) or, in some circumstances you may have to pay additional tax.

Careful planning could save thousands of pounds in tax

A worked example

John, age 57, has a taxable income of £35,000 a year; he’s entitled to his full personal allowance and has no other payments or deductions. As a result he’s a 20% basic rate tax payer. He has pension savings of £40,000 which he’s considering withdrawing in full.

If he were to do this:

  • £10,000 will be tax-free (25% of £40,000)
  • £8,000 will be taxed at 20% (£43,000 - £35,000) 
  • The remaining £22,000 taxed at the higher rate of 40%.

After tax the total amount John receives from his pension savings would be £29,600 (although his pension provider may well only pay out £28,900 immediately after using an emergency tax code, with the rest needing to be reclaimed later).

Total cash after tax: £29,600

If John doesn’t need all the cash now, he has other choices that could be more tax efficient. Ignoring any charges and investment gains or losses, he could take partial cash withdrawals (as per option 1 in the table below) of £10,000 for 4 years, 25% of this will be tax free and the highest rate of tax paid would be 20%, leaving £8,500. John would receive a further £4,400 by making partial cash withdrawals.

Alternatively he could buy a fixed term annuity (option 2 in the table below). In this case £10,000 could be paid tax-free immediately then £7,480 paid annually at the start of each year for 4 years with a maturity value of £600 paid at the end of 4 years. In this example, after tax, the amount he receives would be £4,816 more than just taking a single cash lump sum.

Either of these options could increase cash after tax by over £4,000.

 

CASH AFTER TAX PAID
Tax year 2016/17 2017/18 2018/19 2019/20 2020/21 Total 
Take all cash now £29,600  £0 £0  £0  £0  £29,600
Option 1 - Take yearly withdrawals £8,500 £8,500 £8,500 £8,500 £0 £34,000
Option 2 - Fixed Term Annuity £15,984 £5,984  £5,984  £5,984  £480 £34,416


Note:

The above example is based on 2016-17 tax rates and allowances. Your Personal Allowance goes down by £1 for every £2 that your income is above £100,000.

The example for option 2 is based on Legal & General's Fixed Term Retirement Plan. Other providers’ products are likely to offer different income and maturity amounts which may be higher or lower. We strongly recommend you shop around to ensure you get the best possible deal as some providers may offer product options or take into account factors that we do not. You can get a fixed term annuity income quote online.

What options do I have?

If you don’t need all of your cash immediately you could potentially reduce the overall amount of tax you pay by considering alternative options:

1. Access your money flexibly

The idea is to spread your income over several tax years and to reduce the risk of your income moving you into a higher tax bracket, and so reduce the overall tax you pay. (See example in the table above).

You could take a series of yearly partial cash withdrawals, with 25% of each withdrawal tax-free and the rest taxed as income. Where Legal & General pension products offer flexi-access drawdown, the minimum withdrawal is £5,000 before tax. Partial lump sum withdrawals can be taken a maximum of twice a calendar year. When a lump sum is taken, at least £5,000 must be left in the pension pot. Not all providers or products offer this option and you may have to contact your pension provider every year to arrange each withdrawal.

An alternative is to transfer your savings into a specifically designed product known as flexi-access drawdown. This may be an option with your existing pension savings product.

Again, up to 25% can be taken immediately tax-free with the rest counted as taxable income when it's withdrawn.

This type of contract is designed so it can be set up to pay out a regular income, but if you want to withdraw money as and when you need it you will have to contact the provider each time. Minimum investments in flexible drawdown products may vary with different providers. Both of these options offer the opportunity to take the remainder of your pension pot at any time, giving you additional flexibility.

You should be aware that regardless of which of these options you select the money you leave in your pot remains invested in accordance with your wishes and, whilst your fund could grow, the value could also fall. There is also a risk that it could become totally exhausted if returns are poor, you withdrew funds faster than they were able to grow or a combination of the two. It is therefore important to understand the level of risk you are willing and able to take.

We strongly recommend you shop around. Also, take advantage of the free and impartial guidance from Pension Wise and get financial advice if you need to before you choose any option.

2. Buying a fixed term annuity

If you want the certainty of income payments this option might suit your needs. As with cash withdrawals and flexi access drawdown, up to 25% can be taken immediately as a tax-free lump sum, however this type of product differs in that the remaining pot is then converted into a set regular income amount for a fixed term. With some products you can also choose to include the payment of a lump sum maturity amount at the end of the term, though in doing so the regular income would be lower.

Unlike the previous options the income and maturity amounts are set at the start of the plan and not dependent on investment performance, so you'll know exactly what you'll get and when. However, once you’ve decided on the level of income, the term and the maturity amount (if any), you won’t be able to change it or take extra money out.

To withdraw from a pension pot in a tax-efficient manner, you need to work out the gap between your taxable income (excluding pension withdrawals) and the level of income that you would have to pay a higher rate of tax on. The table below shows the 2016-17 income levels for paying different rates of income tax (assuming full nil rate allowance).

 

INCOME LEVEL PER YEARTAX RATE
Up to £11,000   0%
£11,001 to £43,000  20%
£43,001 to £150,000  40%
£150,001+  45%

Once you've worked this out, it may help you to consider and plan which of the options may be appropriate for you to get this desired level of income.

Important information

The most tax-efficient way to withdraw your pension pot will depend on your individual circumstances. The above examples are based on current law and tax rates and are subject to change.

Taking income from your flexible drawdown will trigger the Money Purchase Annual Allowance.

These are important and potentially life changing decisions. Once your pension pot is exhausted, it's gone for good. It's vital that you ensure you've enough money for your future needs and your money lasts.

We strongly recommend you shop around. Also, take advantage of the free and impartial guidance from Pension Wise and get financial advice if you need to before you choose any option.

Your next steps

Or move on to the next section

Retirement Options which looks at the different ways you can access your pension pot.