Financial Planning

Should I take a tax free lump sum?

Should I take the tax free lump sum from my SIPP? I am worried about changes to tax legislation that may mean the tax free portions will no longer be available. This blog looks at when taking a lump sum is sensible, and when it isn't - regardless of any changes in ability to take the lump sum.

How do I decide when, or if, I should take the 25% tax free lump sum?

When there are rumblings in the press about potential changes to the taxation of pensions, this can cause a certain amount uncertainty.  There is a worry that the tax free lump sum element may suddenly disappear as an option, or worse - the tax free element of withdrawals may disappear entirely!

Depending on your plans for the funds, does this actually matter...

Self Invested Personal Pension (SIPP) Basics

Funds invested in a SIPP have tax benefits:

  • your contributions qualify for tax relief when you put the money into the SIPP
  • they will continue to accrue dividends, interest and capital gains free from assessment to income tax
  • they will not be assessed for Inheritance Tax (IHT), but may be subject to other taxes depending on the circumstances
  • they are subject to income tax at the point they are withdrawn, at which point you may be in a lower tax bracket if you have ceased work.

When funds are removed from a SIPP, these benefits are lost.  Forever.

There are broadly two ways of accessing funds in a SIPP. 

Receive a tax free lump sum of 25%.  Place the entire fund in drawdown and 25% will be immediately available with the remainder being subject to income tax on each withdrawal.

Choose not to receive a lump sum.  Take each withdrawal from the fund with a 25% tax free element and the remaining amount assessed to income tax.  This can be done through a regular withdrawal plan or on an ad-hoc basis.

Should I take the tax free lump sum?

Examples where it can be very sensible planning to take the tax free lump sum:

  • Clear a mortgage and/or debts
    • this can reduce your expense profile in retirement, making your pension income go further
    • this can increase your financial security and give you peace of mind
  • Reduce likelihood of breaching the Lifetime Allowance on future drawdown events or at 75.   This is a complex area and advice may be needed.

Should I keep the money in the pension and use Flexible drawdown instead?

It may be wise to give further thought to your strategy if your plan for the tax free lump sum involves any of the following:

  • Take the tax free lump sum and re-invest it outside the wrapper.  The lump itself is received free of any tax, however, all income and gains will be now be assessable to income tax going forward, at your highest marginal rate.
  • Take the tax free lump sum and re-invest it outside the wrapper.  This brings any unspent portion of the lump sum into the scope of IHT.  If part of your plan is to leave a legacy, depending on the size of your estate, you may have just reduced that legacy by 40% by moving the funds outside the SIPP.
  • Treat the tax free lump sum as a windfall and spend it.  This may put a comfortable retirement at risk.  Even if you have other assets that will generate sufficient income or that can be sold to provide funds, it may be more tax effecient to tap those sources first.

What if the Tax free portion disappears?

The tax free portion is a bonus to encourage people to save for retirement.  The alternative would have been to pay income tax on your earnings when they were earned, instead of putting them to work for you free of all tax, until the money needs to be drawn.  The income is then taxed at the point it is drawn, at your highest marginal rate at that time. 

If you were a higher or additional rate taxpayer when the money was earned. Funds went into your pension on gross basis and grew free of tax. 

  • You draw it when you are a basic rate taxpayer.  You have not only been able to receive income from a much larger investment base but also benefit from a lower tax rate when the income previously earned is drawn out of the pension at basic rate.
  • You draw it and are still a higher or additional rate taxpayer.  You have benefitted from having a much larger investment base, and have deferred the payment of tax to a later date.

If you were a basic rate taxpayer when the money was earned. 

  • We will assume that you continue to be a basic rate taxpayer when you draw the funds.  You have benefitted from having a larger investment base, and have deferred the payment of tax to a later date.  You may also have some personal allowance band available that will make a portion of any withdrawal free of income tax at the time it is made.