What is the pension tax-free lump sum?
You’re encouraged to save into a pension through pension tax relief – basically a government top-up to your contributions.
Income drawn from pensions, however, is taxed, so the government effectively postpones tax. The exception is the 25% tax-free lump sum.
The rules for taking this lump sum vary according to the type of scheme. You can take up to 25% of a defined contribution (DC) pension tax-free once you pass the age of 55.
It’s more complicated if you have a defined benefit (DB) pension, also known as a ‘final salary’ scheme.
How much you can take in one go, and how much your subsequent annual income will be reduced by, depends on what’s called a scheme’s ‘commutation factor’.
Can I withdraw my tax-free lump sum before age 55?
In normal circumstances, no you can't withdraw any of your pension before the age of 55 - without paying a huge tax penalty.
Any pension savings withdrawn before the age of 55 are subject to a huge 55% tax.
Watch out for companies promising early pension access.
Most of these schemes are scams, which come with fees as high as 30%, and the remainder of your fund is often invested in high risk or dubious schemes. Avoid doing this at all costs.
There are some circumstances when you may be able to take a lump sum, or indeed cash in your entire pension, earlier than 55.
If you're in poor health, or you work in an occupation that traditionally has early retirement ages, such as athletes, you could access your money earlier.
But for most pension schemes, the earliest you can access your pension is at age 55.
Taking a lump sum from a defined contribution pension
A defined contribution pension is a personal or workplace pension where you build up a pension pot with contributions from you and your employer, plus any investment returns.
With this type of pension, the decision about whether to take a lump sum has traditionally been more straightforward. But it’s less so since recent pension reforms.
You can take up to 25% tax-free from a DC pension, which means the scheme is ‘crystallised’. This will prompt you to decide what to do with the rest of the fund:
- keep it invested in an income drawdown plan;
- buy an annuity;
- or cash in your entire pension, subject to tax
With more people now choosing the greater flexibility of income drawdown, there’s an argument for keeping your pot intact to enable maximum future investment growth.
An alternative strategy is to use your tax-free entitlement gradually, by taking what are called 'uncrystallised funds pension lump sums', or UFPLS.
Taking a lump sum from a final salary pension
A defined benefit or final salary pension scheme works out your retirement income based on the number of years you’ve contributed into it. The amount you get will be a proportion of your final salary or your career average salary when you come to retire.
The size of your tax-free lump sum, and the impact taking it will have on the rest of your retirement income, will be determined by what's known as a 'commutation factor'.
This is the rate at which you give up the annual pension you will have in retirement in exchange for getting some cash up front.
The higher the commutation factor, the better the deal generally is for you.
How is the pension lump sum calculated for final salary pensions?
The commutation factor is usually decided by the scheme's actuary - the statistical whizzes that ensure pension funds can actually pay out what they have promised.
The maximum you can take from your defined benefit pension is determined by HMRC rules.
The actual figure is then calculated using your accumulated pension and the commutation factor.
However, not all DB pensions work out how much tax-free cash you can take in this way. Some schemes, mainly in the public sector, give you separate entitlements to tax-free cash.
Public sector pension schemes, such as those operated by the NHS and the civil service, and in education, tend to have a commutation factor of 12.
Private sector schemes are more likely to have a higher, more generous, commutation factor of 14 or 15.
The actuary of your scheme will be able to tell you what it is for your pension.
Size and impact of taking a DB pension lump sum
So, how much of a lump sum can you take and how might taking it affect the rest of your pension? Our chart shows the calculation commonly used to work this out.
Let’s say you have an annual income of £20,000 from a defined benefit pension, with a commutation factor of 12.
In our example, you’ll typically be able to take a tax-free lump sum of £85,714 and be left with an annual pension of £12,857.
We've used HMRC's and the pension scheme rules to come up with this figure..
- Calculation 1 – Size of lump sum is: annual pension divided by (3/20 + 1/commutation factor).
- Calculation 2 – Residual pension is: annual pension minus (lump sum/commutation factor).
Where the commutation factor is higher, and therefore more generous, you will get a bigger tax-free lump sum and will lose less annual income.
For instance, using our example from our chart, with a commutation factor of 15 the tax-free lump sum would be £92,308, and you’d only give up £6,154 per year – leaving an annual income of £13,846.
Is it worth taking a final salary pension lump sum?
A crude break-even using our commutation factor of 12 (getting £85,715 up front in return for losing £7,143 each year) would suggest that forgoing the lump sum would prove worthwhile only after 11.5 years of retirement income.
What is an uncrystallised pension lump sum or UFPLS?
The April 2015 pension changes introduced a new, flexible way to take money out of your retirement savings. You leave the money in your current pension fund and take out lump sums when you need to.
The technical term for this is uncrystallised funds pension lump sums (UFPLS).
This just means that you haven't 'crystallised' your pension pot by turning it into an income.
It's similar to using your pension like a savings account, taking cash out when you need, with the rest continuing to grow – but there's usually a lot more admin.
Each withdrawal is 25% tax-free, with the rest charged at your normal income tax rate when your other income is taken into account.
You can only opt for UFPLS if you’ve not already taken any tax-free cash or income from your fund.
If you take a lump sum, or several lump sums, from your pension in this way, the amount you can pay into a pension to earn tax relief falls to £4,000 a year.
How much tax will I pay on a lump sum?
With UFPLS, you can take a series of ad hoc withdrawals from your pension fund or funds as and when you need to access the money.
For each withdrawal, the first 25% is tax-free and the remaining 75% taxed as income.
Once you cash in (or crystallise) your pension pot, you can take up to 25% tax-free up front and the rest is taxable, see our example, above.
Use our pension lump sum tax calculator 2018/19
This calculator applies income tax in England Wales and Northern Ireland. Income tax in Scotland is different - we will be updating the calculator soon.
Emergency tax on pension lump sums
Due to an unfortunate quirk in the tax system, the first lump sum you take from your pension often won't be taxed correctly, meaning that you'll pay more tax than you need to.
Income tax is deducted from your lump sum through the Pay As You Earn system.
But for your first withdrawal, your pension company will not know your personal tax code, or about any income you have from other sources.
Therefore, it applies a 'Month 1' tax code to your lump sum, which assumes the amount you've withdrawn is 1/12th of your annual income.
So, if you withdraw £20,000 from your pension as an uncrystallised fund pension lump sum, the withdrawal is assumed to be part of a £240,000 annual income.
This means you could lose some or all of your personal tax-free allowance and a big chunk of your lump sum could be taxed at the highest 45% rate, even if your total income for the year is much lower.
HMRC should eventually repay this tax to you, ordinarily at the end of the tax year.
But there is a system in place for people to actively reclaim overpaid tax.
Depending on your situation, you can complete one of three online forms to make your claim, and the process should take no longer than four weeks.
- P55 is for those who take out a some but not all of their pension as a lump sum
- P50Z is for those who take out all of their pension and are no longer working
- P53Z is for those who take out all of their pension and are still working
This should only happen on the first withdrawal you make. Any subsequent withdrawals should have the correct tax code applied to it.
Should I take a lump sum?
Not all pension companies will offer UFPLS, so you will need to check with your provider to make sure it's possible if this is your chosen option.
Some employers or pension providers may limit you to one or two lump-sum withdrawals a year, or apply a charge if you take out all your money within a set period of time.
If you go ahead and take sums from your pension in this way, the main things to consider are the tax implications and the possibility of running out of money.
Spreading withdrawals over a number of years can minimise your tax bill and mean that your tax-free entitlement is spread over several years.
Taking lump sums (UFPLS) are worth considering if…
- you want to take varying amounts of money each time
- you want to spread your 25% tax-free allowance over a period of time
- you don’t want to expose your pension to investment risk
- you need to take out a larger lump sum for an emergency.
Taking lump sums (UFPLS) might not be the best option if…
- you think you might run out of money
- you want a regular, guaranteed income for life
- you want to keep your money invested and benefit from growth
- you want to avoid any charges
- you don’t want to transfer to a new provider – not all companies will offer this option.
Can I take my state pension as a lump sum?
Yes, partially. But it depends on when you qualified for the state pension and whether or not you have chosen to delay when you collect it.
You can opt to defer your state pension - that is, collect after your state pension age. Until the state pension was reformed in 2016, you had two options:
- Defer and boost your weekly pay when you finally collect it, or;
- Take the amount you'd deferred as a lump sum.
If you decide to take your deferred pension as a lump sum, you have to put off taking state pension for at least 12 consecutive months.
You earn 2% above the base rate (currently 0.5%) a year. We've explained how this works in our guide to deferring the state pension.
The lump sum option is only available to people who reached state pension age before 6 April 2016. Anyone who qualifies for the state pension after that date can only take extra weekly pension.
Is the deferred state pension lump sum taxable?
The state pension lump sum is taxable at the rate you are currently paying.
So if you're a basic-rate (20%) taxpayer at the time you come to withdraw the state pension lump sum, you'll be taxed as a basic-rate taxpayer, even if the lump sum you get pushes you into a higher tax bracket.
The Department for Work and Pensions, will send you a declaration form when you come to claim, where you'll have to say what rate of tax you currently pay.
HMRC will check this at the end of the tax year, and if two much tax has been deducted you'll get a refund. But if you haven't paid enough tax, you will have to make up the difference.
Pension lump sums: FAQ
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