This term, popularised by final salary pension schemes, is used to describe the act of exchanging pension income for tax-free cash. You may find it cropping up in such phrases as “you can commute part of your pension for a pension commencement lump sum”.
What do you mean by a pension commencement lump sum?
Well, that is simply a cash sum that can be paid to you when you pension starts, and currently it is tax-free.
Why do you say currently?
Because at least once a year there are calls for this tax-free benefit to be restricted either by taxing it to some extent or by drastically reducing the portion of your pension that you can swap for a tax-free cash sum.
Are the rules likely to be changed?
It is hard to say. Tax-free cash benefits higher rate tax payers the most and the sentiment is that it is fair to remove these apparent discrepancies. Yet at the same time we hear that only one in seven higher rate tax payers ends up paying higher rate tax when they get to retirement anyway so perhaps more damage will be done by removing a key reason why people save up in a pension.
So, if given the choice, I presume I should take the maximum offered to me as a tax-free cash sum?
This certainly seems the obvious answer: would you want money dribbled out to you over your lifetime that is subject to income tax, or would you rather the money upfront with no tax?
What complicated matters is that the final salary pension scheme sets the terms on which they reduce your pension for every £1 of tax-free cash you wish to take.
For example, you may be offered an annual pension of £15,000 or instead a tax-free lump sum of £69,230 with a lower pension of £10,385. Would you rather exchange £4,615 of taxable income for a tax-free lump sum of £69,230? Remember that the income that you give up may increase each year, for example by inflation.
Are these terms fair?
The trustees should set terms that are fair but they will be looking at fairness in relation to the entire scheme membership. Broadly, they would want simple terms that they can apply to the whole membership (and so do not take into account your own personal circumstances) and which would leave the scheme generally no worse off whichever route is taken by a member.
Why do my own personal circumstances count?
There are three key factors: how much tax you are likely to pay on your pension income, how long you are likely to live, and what investment return you would get if you had the lump sum to invest. Critically, all three factors are unknown as we do not know what future tax rates will be, how long we are going to live, or how much return we will get on money invested.
How do I decide?
You can take advice on the situation, which can look at your personal circumstances and expected outcomes but ultimately a view has to be taken.
Is it all about a financial assessment?
A financial assessment may reveal that it is better to have a taxed pension income for life than a tax-free cash sum. But human nature often means that the preference is to take the cash available to you when offered.
Anything else to be aware of?
Usually the tax-free cash is funded by reducing only your pension income. If your dependant has a pension payable on your death, this is usually unaffected but check your own scheme rules. Also, it is often the case that taking the tax-free cash means you will use up less of your pension lifetime allowance. This can be a useful way of managing the value of your pension rights if you are in danger of breaching the lifetime allowance.
If you are unsure, you can seek independent financial advice.
Pension & Equity Release
What Is Equity Release?
Equity release is the use of financial arrangements that provide the owner of a house, or other property, with funds derived from the value of the property while enabling them to continue using it.
How Does Equity Release Work?
Equity release is aimed at homeowners aged 55 and over. It allows you to take some of the value of your home as cash.
Tax on Equity Release Income
Dividends from shares held in a stocks and shares ISA or pension are tax-free. The tax rate you pay on dividends that exceed the allowance depends on your income tax band, which you can work out by adding your total dividend income to your other income: Basic rate taxpayers pay 7.5% Higher rate taxpayers pay 32.5%