Final Salary Pension - Tax Free Lump Sum

Chorlie

A friend is about to retire and as me which I think is better, since I retired last year (but I'm not sure I made the right decision).

She is on a Final Salary pension where she can take up to 25% as a Tax Free Lump Sum.

She is 55 yrs old, has no debts or mortgage, has no depends (children or partner) and has some savings (ISA's, NS&I etc), she is comfortable and wants to retire early to enjoy her life.

Now the details she has been sent state she can have a full pension of about £7500 per year (before tax) or take a maximum Tax Free amount of about £34,000 and a pension of about £6,250 per year (before tax).

Her pension is indexed linked to RPI to a maximum of 5% a year.


Can some kind person explain the maths to me, because the more I look at the more confused I'm getting, part of me says put the £34k in a fixed bond at 4% and the interest will be close to the £1,250 after tax, but than doesn't take the 5% RPI link in to consideration, so the £34k isn't increasing and year on year the interest is less compared to the pension. Or do You look at it as £34k divided by £1,250 so it's 27 years of upfront income, that's without any interest....

Is there a simple formula to be able to compare the two options, over a period of time say 20 or 30 yrs?

kidmugsy

A common procedure is to divide the lump sum by the annual income forgone: £34000/£1250 = 27.2. That's such a high figure that I'd start off by checking the facts.

Usually an answer of around 20 is reckoned pretty good i.e. favourable to taking the lump sum: a value of 12 is common for public sector schemes (or so I understand) and is reckoned poor enough that people are commonly advised to take the income rather than the lump sum.

Naturally she should also consider her health record, her parents' ages at death, and so on. She could also consider that she will get an increase in annual income when her State Pension begins, so a lump sum now would help her bridge the gap until that day.

But, as I say, start by checking the facts.

StephenM_2

Has she got any other taxable income. If she hasn't a £7500 pension will be virtually tax free (personal allowance is £7475).

kidmugsy

Oh yes, and before she decides she'd be wise to get an estimate of her eventual State Pension.

dunstonh

There is no way to tell what option is best without knowing a lot more details. The commutation factor may make it better financially (in isolation of other things) to take the income.

Howver, you have the personal circumstances to consider. Poor health and reduced spouse pension benefits (especially if spouse has little or no provision for self) may make it better to take the lump sum. Personal taxation both now and current can come into play. If the total income is going to be over the age allowance reduction figure then reducing the income and taking a lump sum can save around £800 a year extra tax. Things like immediate vesting personal pensions could give a spouse a non-earning spouse around 8% p.a. guaranteed. If the person is capital light then having some capital from the pension is a good idea as income wont cover significant capital purchases.

Sticking the tax free cash into a taxable fixed term deposit paying a lousy interest rate that is never going to compare with the income on the pension unless you die in the short term. Long term, the pension will wipe the floor with the fixed term deposit.

Chorlie

Thanks for that, I'd forgetton to include her state pension; she has her full 30yrs, so unless it changes again, she should get a full state pension and her final salary pension will decrease by just over £900 (I think it said on her letter).

I got it to 27yrs which I thought was good, since she'd be in her 80's.

From memory the reduced amount was £6,200 (and something) and the maximum amount was either £7,500 (and something), I know what I worked it out there was a difference of about £1,250.

The lump sum was just under £34,000 (think it was £33,877).

So when we first worked it out, it seemed a no brainer of take the maximum Tax Free Lump sum and place it in a high interest / income account or Bond and move it into Tax Free Saving / ISA over the coming years, taking monthly interest if needed, otherwise leave it for a rainy day.

But then we started to try and workout how the Index Linked RPI (upto 5%) will effect thing and that's where we get very confused, but I think we maybe reading to much into this, since some years you may get 5% but other Zero so we tried to average it to 3%.

atush

The other way to look at it is can she live on 6,200 plus any interest on current savings and the 34K plus her state pension. If that income isn't sufficent he needs to consider not taking the lump sum perhaps.

Chorlie

From what I know (I don't really want to ask her directly), she lives in her late parents house, so has no mortgage etc, she never married so has no children or partner, is an only child and inherited a lot of money when her mother died last year (I think she once said it was about £100k).

I think, with her parents both passing away within the last few years it made her mind up to retire ASAP and with her having money saved away, she feels secure in doing so.

She also lives cheaply, drives her late mothers old car etc.

NAR

Sounds like good advice would be to retire with max lump sum. Change her lifestyle dramatically and spend, spend, spend for the next twenty uesrs enjoying herself and then worry about who she is going to leave the balance to.

gadgetmind

Chorlie wrote: »

So when we first worked it out, it seemed a no brainer of take the maximum Tax Free Lump sum and place it in a high interest / income account or Bond and move it into Tax Free Saving / ISA over the coming years, taking monthly interest if needed, otherwise leave it for a rainy day.

Dividends are more tax efficient than interest, but it doesn't matter too much for a small sum like that as you can ISA it in just over three years.

bigfreddiel

gadgetmind wrote: »

Dividends are more tax efficient than interest, but it doesn't matter too much for a small sum like that as you can ISA it in just over three years.

why are dividends more tax efficient than interest?