Tax-Free Cash and Pension Commencement Lump Sum

Most people who have a pension want to take the lump sum from it - this is sometimes known as the tax-free cash, but strictly speaking is now the pension commencement lump sum. This lump sum can be used for almost any purpose, such as:

  • Paying off debts and loans
  • Using it for property purchase
  • Paying for a holiday
  • Investing it to provide an income

Practically all pension contracts now offer the facility to take a tax-free lump sum. Changes introduced in April 2006 to pension legislation now mean that contracts which previously did not allow any tax-free lump sum to be taken can now allow some money to be taken as a lump sum. These changes affect contracts which contain protected rights, freestanding AVCs and in-house AVCs. These changes also allow at least 25% of the fund value of Occupational Schemes to be taken as a tax-free lump sum, although many schemes will require the scheme rules to be changed to allow this.

However, if you have a contract which has an element of Guaranteed Minimum Pension (GMP), you need to be aware that you can't take any tax-free cash from this element. It seems that this type of pension was overlooked in the changes to the rules. (You could however transfer it to a personal pension which would convert it and allow you to take 25% of the fund as a lump sum, but there are some disadvantages to doing this.) See Guaranteed Minimum Pension for more details.


You do need to be aware that if you have an occupational pension that you might have a protected amount of tax-free cash, which could be greater than 25% of the fund value. If this is the case, then you would probably want to take as much tax-free cash as possible.


Should you take the lump sum from your pension?

The answer to this question depends on your circumstances, and the type of contract you have. But there are some important points you need to consider:

Money Purchase Pension Schemes (personal pensions and defined contribution schemes)

Generally speaking, it does make more sense to take the tax-free cash from these types of schemes. The reason is that the tax-free cash is, of course, tax-free and it is possible to invest the funds in a tax-efficient environment to provide an income. If you buy an annuity, the income is taxable at your highest rate and for most people this means at least 20%, but of course, could be as high as 50%.

However, there are some instances when you need to consider perhaps not taking any tax-free cash, and that is if your existing contract has guaranteed annuity rates. If the guaranteed annuity rates are high, it may mean that even after tax, it provides a better income than that available elsewhere, with no risk to your income.

Final Salary Pension Schemes

With some schemes it is compulsory to take the tax-free lump sum, whereas some other schemes give the option to take a reduced pension and a tax-free lump sum, or a higher pension. This needs some careful consideration. In many instances, it does not make sense mathematically to take the lump sum, because the income you give up is worth more than the lump sum you receive. This is because the income they provide has to have some inflation proofing and also usually provide an income for a spouse. Very often, the tax-free lump sum they provide does not reflect the true value of the income given up.

Legislation now also permits 25% of the notional fund to be taken as a lump sum from a final salary scheme. This can be higher than under the old rules. However, the scheme rules also need to be changed to enable this to happen.

If you have a question about your pension and taking the lump sum, or just want to discuss your pension in more detail then phone us on 0800 011 2713 or Contact us online.


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