Make the most of your pension pot

Should you take 25% of your pension as a tax-free lump sum on retirement - or use it to increase your yearly income?

We all love the idea of getting one over on the tax man. So if you're approaching retirement, you may think taking a quarter of your pension pot tax-free is a real no brainer. But be careful. As with all things financial, the decision isn't quite as clear cut in practice as it seems in theory.

Pension rules

First things first, let's be clear on the rules. As long as your pension pot does not exceed £1.65 million (rising to £1.8 million by the 2010-2011 tax year), you're allowed to take up to 25% as a tax-free lump sum. (These days you might see it called a pension commencement lump sum, but it's the same thing.) The rest of the pension fund is then normally used to buy an annuity which converts it into a guaranteed income for the rest of your life.

So, if you take the tax-free cash, the total value of your pension pot will be reduced by 25%. This means you will get a lower yearly income in retirement.

Still, when you take into account that you'll pay tax on this yearly income, it may seem sensible to take the full cash lump sum.

But, would it surprise you to hear you could squeeze more out of your pension pot by taking it all as a taxable income instead?

The figures below show the total amount you could receive if you chose to take the 25% tax-free lump sum, compared with taking 100% of your pot as a taxable income.

In this example, the following assumptions are made:

• The pension pot is worth £50,000.
• Maximum tax-free cash is £12,500 (25%).
• The annuity income is 'level' - that is fixed at the same amount each year.
• The annuity is guaranteed to pay out for at least five years regardless of how long you survive.
• The annuity income is based on a man age 65
• Average life expectancy for a man age 65 now is just over 82 years (according to the Office for National Statistics.)

Tax-free cash versus a fully taxable income

*Annuity rates provided by the Annuity Supermarket

As you can see, if you took the maximum tax-free cash of £12,500, your yearly annuity income would reduce to £2,742. But by giving up the tax-free cash, you could buy a higher yearly income of £3,646.

In both cases, if this was your only income, it would fall within the personal allowance threshold - so would not be subject to income tax.

Which option is better?

It depends on how long you survive after buying the annuity. If you only survive for five years, you'll have received more money back by taking the tax-free cash option - £26,211.80 instead of £18,233. The same is also true if you survive for ten years.

But if you live for 15 years after retirement or until average life expectancy, you'll actually receive more money overall by taking the higher yearly income and no tax-free cash. In fact, the longer you survive beyond average life expectancy the better off you'll be with a higher taxable income.

That said, the figures above assume that you spend the tax-free lump sum. Instead, you could invest it or stick it in a bank and earn interest on it, which would boost the amount you would receive overall. Of course, the reverse would be true if you invest the cash and its value falls.

Other factors to think about

Obviously, there's no way of telling how long you'll live, which makes it difficult to select the best option. Annuities are often criticised because capital is lost on death. In other words, your annuity income normally stops when you do. If you were to die soon after buying the annuity, you would lose out. But you can partially protect against this risk by taking the tax-free cash up front.

You might also want to think about taking tax-free cash where a higher pension income would push you up into a higher tax bracket. Remember, your annuity is taxed in the same way as your pre-retirement salary. But if taking tax-free cash and a reduced income, means you'll be in a lower tax bracket, then you would be better off from a tax perspective.

When deciding what to do, it's worth bearing in mind that, once you turn 65, you will benefit from a larger-than-normal personal allowance, as this table shows:

Unfortunately, this enlarged personal allowance starts to reduce once you earn more than £21,800 (£22,900 for the 2009-2010 tax year). It is cut by £1 for every £2 you earn above this 'income limit for age-related allowances', until it gets down to the usual size for people under 65 (currently £6,035). There are also Married Couples allowances for people born before April 1935 - find out more here.

So if taking your tax-free lump sum means you lower your income and get to retain more of your personal allowance, it is a tax-efficient option. Then again, it does mean your income will be lower than if you hadn't taken the 25% lump sum.

That's why, above all, it's a question of affordability: Can you afford to live off a lower income once you've taken the tax-free lump sum? If you can't, then you'll probably have to go for a higher annuity income.

What should you do with your tax-free cash?

You can make up for a reduced income by investing your lump sum. But that could be a risky strategy if you don't invest it well. If you're relying on this sum of money to supplement your income, it's a good idea to speak to a good independent financial adviser first.

Alternatively, you could simply deposit the cash in a savings account, although this isn't a particularly attractive option when interest rates are as poor as they are today.

Remember a chunk of tax-free cash could give you the flexibility to clear any outstanding debts as soon as you retire, putting you in a stronger financial position.

Purchased life annuities

If you don't want to handle a large lump sum, you could use your tax-free cash to buy what's known as a purchased life annuity (PLA). This works on the same principle as a standard annuity by converting a lump sum into a guaranteed income. But the money can't come directly from your pension. You can buy a PLA using any other capital, including your tax-free cash and any other savings you have.

PLA's are taxed more favourably than standard annuities, so you could receive more income after tax has been deducted. Your PLA is divided into two separate parts - capital and interest. The capital part is counted as a return of your own money, and so it's not taxed. The interest part is counted as unearned income and is usually taxed at the basic savings rate (i.e. 20%). This makes a PLA more tax-efficient than a standard annuity.

You'll need to do some number crunching - or get an adviser to help you - but a PLA could be a good home for your tax-free cash. But don't forget, like traditional annuities, income from a PLA is normally lost on death too.

There's no question taking tax-free cash is a more complex financial decision than it seems. If you're in any doubt, make sure you speak to an expert. Good luck!

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