The tax-free lump sum when you first draw you pension could be worth many thousands, so you need to use it wisely
As a reward for diligently saving in a pension scheme throughout your working life, the taxman gives you a nice little bonus right at the end. When you finally draw your company or personal pension, you can take 25% as a tax-free lump sum to spend on whatever you like. (Sadly, you don't get the same from your state pension.)
This lump sum could be worth many thousands of pounds, depending on the size of your pension, so you need to use it wisely.
You are not obliged to take any or all of it , but most people should seize on this rare free gift from the taxman, according to Craig Palfrey, a certified financial planner at Penguin Wealth. "This is the only part of your pension that isn't subject to tax. If you add it to the rest of your pot and use it to buy an annuity [an investment that pays an income for life], the income will be taxable."
There is one main exception to this rule, Palfrey said. Some older pension schemes offer guaranteed annuity rates, which are far more generous than anything you could get on the open market today. If your pension offers this, you may want to plough your full pot into that annuity.
What to do with it
Although you do not pay tax when you draw your 25% lump sum, you may be taxed on any income it subsequently earns, Palfrey said. "You should use your annual tax-free Isa allowance to shelter the money from HM Revenue & Customs. You can pay up to £11,280 into an Isa this financial year, which rises to £11,520 from 6 April, and take any returns free of income tax and capital gains tax."
Every UK adult has their own annual Isa allowance, so couples can stash away double that annual amount.
You might be tempted to give some of your tax-free cash to your family, say to help children or grandchildren fund university studiese or get onto the first rung on the property ladder. "But in practice, most people will need every penny themselves to generate income in retirement," Palfrey said.
Nearly one in five people planning to retire in 2013 will have unpaid debts such as mortgages and credit cards, worth an average of £31,200, according to Prudential. The tax-free cash will be the only way for many to clear this burden, said Phillip Bray at Investment Sense. "This could be your last chance, so make the most of it. There is no point earning 2% or 3% interest from a savings account if you're paying 20% on a credit card."
If you are ploughing some of your cash into an Isa, you have to decide whether to invest it in cash, stocks and shares or a combination of the two. You can put up to £5,640 in cash into a low-risk cash Isa in the tax year to April 2013 and invest a further £5,640 into stocks and shares. Alternatively, you can invest your full £11,280 allowance in stocks and shares.
What you do largely depends on your attitude to risk, Bray said. "If you are cautious and want to guarantee your capital will never fall in value, then you may want to stick to cash."
With interest rates stuck at historic lows, more pensioners are being pushed into the stock market in the hope of generating a higher return. In the longer term, stocks and shares are more likely to beat inflation and maintain the value of your capital than cash savings, but they carry additional risk.
You can reduce the risk by taking out an investment fund that spreads your money between a range of different stocks. Equity income funds are particularly popular among retired people, because they invest in solid blue chips and offer a combination of rising income and capital growth (provided stock markets rise). Popular funds include Artemis Income, Invesco-Perpetual Income and Schroder Income Maximiser. You could also generate income from a corporate bond fund such as Invesco Perpetual Monthly Income Plus or Henderson Strategic Bond.
There is another option called a purchased life annuity (PLA), which Bray describes as the best kept secret of retirement planning. "This works like a standard annuity, except you pay less tax on the income because the taxman treats it as a return of your own capital," he said. "Buying a PLA with your tax-free lump sum and a traditional annuity with the remaining 75% of your pension will usually give you a higher net income than using your entire pot to buy an annuity."
Final salary schemes
If you are one of the rapidly dwindling number of people with a final salary company pension scheme, where your payout is based on your earnings and guaranteed for the rest of your life, you should think twice about taking a tax-free lump sum, according to Mark Swann, the director at annuity experts Simply Retirement. "Final salary pension schemes offers such attractive benefits, including inflation-linked income and a spouse's benefit on death, that you would struggle to get a better deal by taking your 25% cash and investing it on the open market."
For the vast majority of pensioners, who have less attractive "money-purchase" company and personal pensions, taking the tax-free cash is usually the best option, Swann said, adding that you may need to take independent financial advice when deciding how to invest your lump sum. "Unfortunately, you need at least £50,000 in your pension pot to make it cost-effective to employ an adviser, and most people don't have that. The average pension at retirement is closer to £30,000."
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