Should you take the Tax Free cash from your pension?

Traditionally the answer was yes, and for many that will still be true. But it's not the most efficient way of doing things for everyone.

Defined Benefit (aka Final salary)

With these schemes you typically are offered two main options at retirement

1. A full pension with no, or limited tax free cash
2. A reduced pension plus a larger sum of tax free cash

Which should you choose is really driven by the numbers AND your thoughts on how long you’ll live.

For example.

A ) Scheme offers ￡8,400 per annum pension, index linked

OR

B ) ￡6,300 pa PLUS ￡42,000 tax free cash.

If we keep it simple and assume your personal allowances are all used up.

The pension is taxed at 20% means that A will give you ￡6,720 pa net and B ￡5,040, a difference of ￡1,680 per annum.

If you were simply to take this ￡1,680 from the ￡42,000 tax free pot then it would mean you were ahead of the game for the first 25 years, when the total received would be equal. If you die before that you would be ahead.

However, the calculation is not that straightforward because you have to factor in the indexation, which is not a fixed percentage and has a larger impact on A.

You also have to allow for possible interest or investment growth, depending on where you put the tax free cash. For example, at present interest rates you would cover the income shortfall from the interest generated, meaning that the tax free cash would last more than 25 years.

So if you expect to die sooner than later, taking the tax free cash up front is the clear choice to maximise the total amount you get back from the pension. The longer you live the less obvious the choice becomes.

Defined Contribution (or investment based)

Annuity Option

If you choose an annuity at retirement then it’s basically the same as the Defined Benefit option, depending on the options that you choose in the annuity.

Drawdown Option

This is the more complex option.

If you take the tax free cash up front you will end up with less overall.

For example, you have a ￡400,000 fund.

Option C - You take 25% tax free up front = ￡100,000 tax free cash.

￡300,000 fund is now in drawdown and grows at 3% per annum (I chose 3% only for illustration of the point)

You draw regular taxable income of ￡5,000 = ￡4,000 net (after ￡1,000 tax)

In 10 years your fund has grown to ￡351,000

You have no tax free cash left, so all withdrawals are taxable

Total tax free cash ￡100,000

OR

Option D - You draw No tax free cash lump sum up front

You draw income of ￡4,706 (￡294 less than before)

Of this 25% is tax free cash = ￡1176.50

This leaves ￡3529.50 taxable at 20% leaving ￡2823.60 after ￡705.90 tax

You end up with ￡4,000 in total, the same income as option C

In 10 years your fund has grown to ￡415,000

Note that 25% of this new amount is still available as tax free cash = ￡103,750

You’ve already had ￡11,765 tax free, so the total is nearly ￡15,000 more tax free after just 10 years

The longer it goes on the more tax free cash you get.

If you die in drawdown you leave ALL of the funds to someone else.

So taking tax free cash up front isn’t necessarily a good idea, unless it’s needed for a purpose. But remember you don’t have to take it all at once.