Pensions are complicated financial products and knowing how best to use yours once you reach retirement can be difficult. With various options available to you for your retirement income, it isn’t always straightforward knowing which one is going to be right for you and your future. One of the main talking points of taking a pension is the Pension Commencement Lump Sum (PCLS).
When you are deciding what to do with your pension, and how to manage your retirement funds, you should fully understand all the options available to you. This guide covers everything you need to know about Pension Commencement Lump Sums, including what they are, how they work, and whether you should consider taking yours.
What is the Pension Commencement Lump Sum?
When you reach your retirement age and begin drawing on your pension savings, you could be able to take some of your pension pot as a tax-free cash lump sum. This tax-free cash is called the Pension Commencement Lump Sum, and you are free to take it or leave it as you please. In most cases, this tax-free cash amount is 25% of your pension pot, and can be taken in one go and spent as you wish.
If you have an older pension, then you may be eligible to take more than 25%, and you are not obligated to take the full percentage amount if you do not want to. The remainder of your pension fund can then be used to provide a regular income for your retirement, either through an annuity or other drawdown option.
Remember that the more you take out of your pension pot as the Pension Commencement Lump Sum, the less you will have left in your pension to use as regular income.
The Pension Commencement Lump Sum and tax allowances
However much you choose to take as a Pension Commencement Lump Sum will be completely free of all taxes when it is paid to you from your pension provider. If you are a member of a defined contribution pension scheme, then you will have full flexibility over how you draw down the remainder of your pension pot after taking your Pension Commencement Lump Sum.
These drawdown amounts will be taxed as regular income, and it is vital that you check if these taxable withdrawals will put you into a higher tax bracket. In some circumstances, you could end up taking a large amount of your pot in one tax year and have to pay income tax of 40% or higher.
If you are a member of a defined benefit pension then you should check with your pension provider what your options are, as many of the flexibilities that came into effect in April 2015 will not apply.
What to consider when deciding to take your Pension Commencement Lump Sum?
It can be tempting to just take the maximum amount of tax-free cash as soon as it is available to you, however this might not always be the most sensible option. You need to consider how this money can affect your retirement income in the future, and what benefits there are to taking it all or leaving it. The main things you should consider are:
- It’s tax-free cash, not free cash: When you take the full tax-free lump sum, you need to remember that this is taking income from your future pension. It is essentially giving up part of your guaranteed income for the rest of your life.
- Value for money: It might seem obvious that taking your Pension Commencement Lump Sum will give you the best value for money because of the tax benefits. However, this isn’t always the case as it completely depends on the type of pension you have.
Investing after retirement: More and more people are choosing to leave some of their pension pot invested after they have retired. If you are considering this option, then be aware that the more you take as cash, the less you will have left to invest.
- Income drawdown: If you choose to use your pension for income drawdown as opposed to an annuity, then you may want to maximise tax relief. If you take your Pension Commencement Lump Sum then you will get tax relief on this, however if you then invest that money in future then it might be subject to capital gains tax.
In some situations, taking the full Pension Commencement Lump Sum makes financial sense, however this isn’t always the case. There is no obvious decision for what the best choice for your future will be, and if you are unsure then it is often worth seeking independent financial advice.