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Four things to consider before taking a tax-free lump sum from your pension

The Pension Freedoms reform means that you can access 25% of your pension fund on a tax-free basis from 10 years prior to your State Retirement age (also known as a Pension Commencement Lump Sum). More than half (54%) of people plan to take advantage of this, according to research from Aegon.

But, is it always a good idea?

According to the study, the average 55-65 year-old has a total of £105,496 in their pension pot, allowing them access to approximately £26,000 of tax-free cash. There are a range of ways in which people intend to use this sum, including:

  • Putting it into a cash ISA (17%)
  • Transferring into a bank account (15%)
  • Going on holiday (14%)
  • Buying a property (12%)
  • Clearing debts (10%)

Before deciding to join these people, there are a few factors to consider:

1. Is a lump sum necessary?

It is important to distinguish between things that you want and things that you can reasonably attain. For example, going on holiday is a nice thing to do, but it may be equally possible to do so by saving over a few months. Remember that taking money from your pension pot now means that you are left with less capital for the future.

You could be forgiven for seeing the amount that is available to you on a tax-free basis and treating it like a lottery win. But, it is important to keep one eye on the future when spending for immediate gain. Remind yourself that you have saved for tens of years to be able to have this money and consider how you spend it very carefully.

Accessing cash to pay off immediate debts and put you into a better financial position is often sensible. Indeed, that’s arguably the most suitable reason for accessing a tax-free lump sum. It’s those who have no immediate plans for the money and who just want to access it because they can, who may face difficulties later.

2. Does your plan make financial sense?

It is important to ensure that your financial plan is the most effective for your circumstances, you need to consider:

  • Accounting for your life expectancy
  • Whether tax-free cash is better held back for later life
  • Is your future financial security affected by your impending plans (such as taking a lump sum)?

3. How will your future be affected?

For many people, planning for retirement and thinking about leaving a legacy go together. If you want to leave money for loved ones or good causes, the bigger your pension pot, the better. By leaving a higher amount in your pension fund, your loved ones will benefit from higher growth and a potential tax-free inheritance.

If you choose to access the lump sum, you are not obligated to take the entire 25%. This is important to remember when you consider that any money you spend now is then unavailable to support your lifestyle in retirement.

4. Why should you take advice?

The type of pension you have may mean that you are subject to different regulations and the way you withdraw money from your fund can differ between providers. Therefore, it is strongly advised that you seek independent financial advice before making any decisions regarding your pension funds. A financial adviser will be able to tell you how your current actions may affect your future income, as well as offering alternative methods of managing your finances.

If you want to see how financial advice can help you to plan for retirement, get in touch.

Please Note:

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.