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Pensions: should you take your tax-free cash? By Sam Barrett
Beating the taxman is one of the golden rules of financial planning. Strategies such as tax-efficient investing and inheritance tax planning are useful ways to increase your wealth and reduce your tax bill. However, when it comes to taking the The new pension rules, which came into effect on 6 April 2006, allow you to take up to 25% of any pension scheme as tax-free cash. Taking such a large lump sum can be very tempting. "With a money purchase or personal pension taking the cash now does seem a good option, especially as it's tax-free and any income you receive from your pension will be taxed," says Des Hamilton, technical director at The Pensions Advisory Service. He adds that with annuity rates historically low the temptation is even greater. If you have a large pension fund, taking the full 25% tax-free cash could potentially save you even more tax too. Douglas Jones, head of individual pensions marketing at Scottish Equitable, explains: "If the full annuity could push you into a higher income tax bracket then you might want to consider increasing the amount of tax-free cash you take." Taking your full tax-free cash entitlement also gives you added freedom. "Having a lump sum upfront will give you a lot more flexibility than if you took it as a regular income through an annuity," says Nicholas O'Shea, managing director of Canterbury-based IFA Pharon. But taking the full 25% can have serious implications for your spending power. "If you do take the tax-free cash you'll receive a lower income from the remaining pension fund," warns Lynn Webb, a spokesperson for Legal & General. For example, if you had a pension fund of £100,000, this could be converted into an annuity of £7,089 a year at age 65, according to Legal & General. Take £25,000 as tax-free cash and your annuity would be reduced to £5,309 a year. Earning interest or investment growth on the tax-free cash can make up for this difference but, because you've taken a lump sum rather than using it to provide an income for life, this shortfall could cost you greatly if you live longer than average. Reducing the size of the fund with which to buy an annuity could also make a difference in terms of the value for money you get as annuities have set charges. Final salary schemes Deciding whether to take tax-free cash from a final salary scheme can be particularly difficult as, unlike a defined contribution scheme, there is no pot of money to base your decisions on. To muddy the waters still further, a new calculation may actually leave you out of pocket. As an example, Andrew Tully, marketing technical manager at Standard Life, considers the case of someone who has worked for 30 years for one company and had a final salary of £48,000. With many schemes they would receive a pension of 1/80 x 30 x £48,000, which is equal to £18,000, with tax-free cash of 3/80 x £48,000, equivalent to £54,000. The new formula for calculating benefits is more complex and uses what is known as the 'commutation factor' to determine how much pension income you lose each year for the tax-free cash you take. The trouble is that many schemes have commutation factors that are too low. For example, a fairly typical commutation factor is 12:1. This means that for every £12 of tax-free cash you take your annual pension will reduce by £1. Based on the above example, if the scheme had a commutation rate of 12:1 at age 65, they would now be able to take a lump sum of as much as £96,435 according to Tully, although this would mean their annual pension would be reduced to £14,465. "Assuming inflation of 2.5% a year, they would only need to live for another 13 years to receive more money over their retirement by choosing to take the income rather than the tax-free cash," says Tully. Given that the average life expectancy of a 65-year-old man is 16.37 years and, for a woman, 19.26 years, this is rather in the pension scheme's favour. "There is a degree of profiteering going on," says Tom McPhail, pensions research manager at Hargreaves Lansdown. Commutation factors do vary across schemes and not all are weighted so much in the pension scheme's favour. Additionally, the factor should reduce with age, as an older person would have a shorter life expectancy. Some final salary schemes offer a way round this, allowing you to pay extra contributions to an additional voluntary contribution scheme (AVC) to fund the tax-free cash. Whatever type of pension you have, another factor that you might want to take into account when deciding how much tax-free cash to take is your health. With calculations based on life expectancy, if you suspect you're unlikely to clock up the average number of years you may want to maximise the amount of tax-free cash you take.
Using your tax-free cash It can be very tempting to use your tax-free cash to go on a spending spree. The more prudent course, however, would be to use it to provide a supplementary income, with many IFAs favouring tax-efficient investments for this. If the idea of a guaranteed income for life appeals you could use your tax-free cash to buy a purchased life annuity. These work in the same way as pension annuities but are taxed in a slightly different way. Anything you receive from a pension annuity is subject to income tax, but with a purchased life annuity, the bulk of the money you receive is regarded as a return of capital and therefore not subject to tax. The remainder, which is the interest your money earns, is taxed as savings income. Clearing debt is another sensible option, or giving money to children and grandchildren, which has the added advantage of potentially reducing future inheritance tax liabilities. Tax-free cash rules The pensions simplification legislation introduced a level playing field for tax-free cash. Under the new rules, all pension policyholders are able to take 25% of their fund tax-free. This was always the case for personal pensions, but this is a new requirement for all the other schemes such as additional voluntary contribution (AVC) schemes and protected rights schemes. For occupational schemes, the new rules will see some employees entitled to more tax-free cash and others less. Entitlement was based on a calculation involving the number of years' service and the employee's final salary. This meant that some employees could build up entitlements as high as 50% of their benefits, while others were entitled to significantly less than 25%. Not all schemes, however, will offer the full entitlement to tax-free cash. There is no obligation on the trustees of occupational schemes to amend their rules to give employees an automatic right to the full 25%.
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