Tax free lump sum and finishing dates

Prudent

I am wondering if anyone can help clarify the situation with a tax free lump sum please.

I am in a final salary scheme. I have a long term illness and applied for ill health retirement. I received a letter yesterday saying that my application has been successful.

The letter asks for me to agree a date with my employers for termination of my employment and to write back to the pension provider with that date. I work for a large employer and I spoke to a number of people on the phone this morning, but was told all of the people who would know that information are on annual leave. My immediate line manager thinks the date has been set at 28/6. I have been off sick since last September and my sick pay ended on 10/4.

I was a bit confused as to which date to give, so I phoned the pension provider who said the pension starts on the date of my application which is 15/6. If my employer gives a termination date of 28/6 does this mean that I will be taxed on my lump sum?

jamesd

There are many kinds of lump sum but the most common one is the Pension Commencement Lump Sum, which is most often called the tax free lump sum. This is entirely free of tax regardless of whether you're working or have any other income. The same applies whether it's a defined benefit pension like yours or a defined contribution one, never tax to pay on it.

For those with defined contribution pensions it is possible to also take taxable lump sums beyond the 25% and those are treated as PAYE income, though without any NI obligation, just income tax.

So you can relax about the tax on the tax free lump sum whatever the date used is.

The regular monthly pension income will be subject to income tax and your pension provider will send you normal pay slips but with no NI to deduct because pension payments are never subject to NI. They might ask you for your P45 or if you don't have one end up temporarily using the emergency tax code until they get a tax code from HMRC. You can usefully tell HMRC about your situation so they can get you a new tax code. That might get you a tax refund via PAYE since you've probably been paying more tax than will be due for this year.

jamesd

It's often not a good idea to take a tax free lump sum from defined benefit pensions. The trade off in reduced income per Pound of lump sum tends not to be good. However this does require considering things like life expectancy and if yours is reduced the largest available tax free lump sum can often be the best choice.

If your condition very greatly reduces your life expectancy it can be a better move to transfer the pension to a personal pension instead of taking early retirement. This depends hugely on just how much reduced the life expectancy is and then on the transfer value. I doubt that you'd want to investigate this but it's worth mentioning just in case the reduction is so large that it would be worth considering.

We don't know enough about your situation to comment much more than with these generic observations about possible things to consider.

Prudent

Thank you both. I don't have a choice about the minimum lump sum. My scheme is 1/80ths plus a lump sum of three times the annual pension. This element is tax free. I can opt to take a larger lump with a commutation rate of 1 in 12. I expect to live a lot longer than 12 years after retirement as my condition does not reduce my life expectancy, so have opted for the compulsory minimum only.

My pension will be below the tax threshold. I got the lower rate (pension accrued to date and no added years) which allows me to work again as long as it is not in my existing occupation. I will contact HMRC, thank you as I had not considered that point.