A question about using tax free lump sum first

Sterlingtimes

This is an artificial set of numbers so that I can pose a question.

Suppose that I have a DC pension pot of £360k (in addition to other pensions).

I might retire at 60 and want to draw £15k per year for 6 years from my DC pot until my state pensionable age of 66.

So I could take 6 times £15k from the 25% tax free cash (at one extreme) or take £15k from the 75% pot and park the tax free cash (at the other extreme).

If I then die at age 66, my family takes £280k tax free in either case from the remaining DC pot.

But in one case I have paid £90k at 20% tax = £18k.

Do the new rules favour taking (and where appropriate living off) the tax free cash first?

Linton

Leaving taking the taxed part of the pension until you reach SPA would cost more in tax than using up your tax allowance during the first part of your retirement if this wasnt covered by other income.

PS this is if you didnt die early.

Sterlingtimes

Thank you, Linton

I was rather assuming that other income would use up the tax allowance, so any income would be taxed at 20%. So is it wise to take the tax free cash first for income?

reeves100

The answer to your question is a generic ‘Yes’.

But you should also consider your income tax position.

If for example you have no other source of income you could crystallise a sum of £13,333 each year (assuming allowance is £10,000 before income tax would apply) £3,333 of which would be tax free (25%) but the remainder (£10,000) would also be tax free as it within the stated allowance.

This is a phased drawdown and the remaining pot of money in this example would still be held within your pension.

Another consideration would be potential inheritance tax. If for example your estate could potentially fall into this bracket, then you would be wise to phase (as above) the crystallisation of your fund. Taking the max tax free cash and allowing it to lie in your estate may not be ideal in every situation and also whilst pension death benefits remain free from tax.

One area for caution!! In practice care needs to be taken to ensure that the pension provider/investment platform has the right tax code for you! This could save a lot of hassle for you.

kidmugsy

Sterlingtimes wrote: »

I was rather assuming that other income would use up the tax allowance, so any income would be taxed at 20%. So is it wise to take the tax free cash first for income?

That depends on (i) whether you plan to die shortly after your state pension begins, or at least before age 75, (ii) whether you are confident that the basic rate will stay at 20%, rather than increase, and (iii) whether you are confident that the flexibility and death tax laws will all be enacted and then remain unchanged indefinitely.

jamesd

If there's no tax rate change it's pretty much moot whether you take the tax free lump sum at the start or later.

Quite often what happens is that people start out in 20% and end up with some income in the 40% band once the state pension starts. In that case it would be beneficial to start to draw on the pension pot up to the basic rate tax limit earlier so you avoid higher rate income tax.

What I would do is try to take money out of the pension and reinvest it inside ISA investments as rapidly as practical. This is to protect against possible future increases in income tax rates and possible future reductions in pension flexibility.

When taking the money as rapidly as practical you can gain some death benefit advantage by using the uncrystallised funds pension lump sum (UFPLS) rules being introduced from 6 April 2015. This takes the money as 25% tax free and 75% taxed while leaving the rest of the pot uncrystallised. On death before age 75 under the new rules this uncrystallised part would be inheritable tax free so there is potential benefit from leaving it intact for a while.